Dividend Reinvestment Plan (DRIP) Definition: Day Trading Terminology

A dividend reinvestment plan, or DRIP, is a broad category of special arrangements for the reinvestment of equity dividends back into the issuing company.

Most DRIPs are issued by the relevant company, and contain additional restrictions and benefits beyond owning regular shares. However, many brokers also offer DRIPs that simply use dividend income to automatically purchase more shares of the issuing company.

Structure of DRIPs

Most DRIPs offer investors the opportunity to reinvest in the issuing company by purchasing non-standard shares that are issued directly by the company. These shares are usually non-tradeable and must be redeemed directly with the issuing company.

Advantages of DRIPs

DRIPs have a number of potential advantages over purchasing normal shares with the accrued dividends.

Commissions

Since most DRIPs are issued directly by the relevant company, there are no broker fees or commissions for the purchase and sale of these shares. Broker fees and commissions can can take a significant portion of potential profits, particularly when a DRIP is benefiting from the effects of compound interest over many years of even decades.

Discounts

Many of the shares issued in DRIPs come at a significant discount from their market price, with anywhere from 1% to 10% being the norm. This significant discount will also boost investor profits, once again particularly when the effects of long term compound interest apply.

Taxes

In many jurisdictions, DRIPs are an effective means for reducing or avoiding the ultimate tax burden of dividends. In most jurisdictions dividends are seen as taxable income, which is usually a higher rate than the prevailing capital gains tax.

DRIP dividends are never formally issued, and are instead automatically reinvested in the company as a share purchase. Therefore, DRIPs transform dividend income into a capital gain, which often faces a lower rate of taxation. Furthermore, if the DRIP is in a relevant retirement savings plan, such as an IRA, then the capital gains tax can be deferred, which further extends the gains from compound interest.

Fractional Shares

Since the shares issued from DRIPs are not actual ‘shares’, there is no need for equity purchases to be in whole unit terms. This allows DRIPs to use the full value of a dividend issuance in reinvestment, with no left over dividend due to the precise stock unit cost.

DRIPs and Trading

While DRIPs tend to be more of an issue for retirement investing rather than active trading, they do have an impact on a company’s finances and value structure. When analyzing a company’s finances, it is important to know what a DRIP is and how it will alter the company’s key metrics, such as its debt to equity ratio.

Final Thoughts

DRIPs often offer a substantial benefit to investors over receiving dividends, particularly when the investor intends to hold the issuing company’s stock for many years or even decades. However, the additional restrictions that DRIP purchases face do make them less appealing to more active traders.

Despite the significant impact that DRIPs can have on a company’s finances, few traders and investors are aware of their existence.