Pros and Cons of Dividend Reinvestment Plans for Stock Investors
In spite of the fact that more dividend reinvestment plans (DRPs) are charging service fees, DRPs are still an economical way to invest in stocks, especially for small investors. The big savings come from not paying commissions. Although many DPPs and DRPs do have charges, they tend to be relatively small (but keep track of them, because the costs can add up).
Some DRPs actually offer a discount of between 2 and 5 percent (a few are higher) when buying stock through the plan. Others offer special programs and discounts on the company’s products and services. Some companies offer the service of debiting your checking account or paycheck to invest in the DRP. One company offered its shareholders significant discounts to its restaurant subsidiary.
When you’re in a DRP, you reap all the benefits of stock investing. You get an annual report, and you qualify for stock splits, dividend increases, and so on. But you must be aware of the risks and responsibilities.
So before you start to salivate over all the goodies that come with DRPs, be clear-eyed about some of their negative aspects as well. Those negative aspects include the following:
You need to get that first share. You have to buy that initial share in order to get the DRP started (but you knew that).
Even small fees cut into your profits. More and more DRP administrators have added small fees to cover administrative costs. Find out how much they are and how they’re transacted to minimize your DRP costs. The more costs you incur, of course, the more your net profit will be diminished over time.
Many DRPs may not have added services that you may need. For example, you may want to have your DRP in a vehicle such as an Individual Retirement Account (IRA). Many investors understand that a DRP is a long-term commitment, so having it in an IRA is an appropriate strategy.
Some administrators have the ability to set up your DRP as an IRA, but some don’t, so you need to inquire about this.
DRPs are designed for long-term investing. Although getting in and out of the plan are easy, the transactions may take weeks to process because stock purchases and sales are typically done all at once on a certain day of the month (or quarter).
You need to read the prospectus. You may not consider this a negative point, but for some people, reading a prospectus is not unlike giving blood by using leeches. Even if that’s your opinion, you need to read the prospectus to avoid any surprises, such as hidden fees or unreasonable terms.
You must understand the tax issues. Just know that dividends, whether or not they occur in a DRP, are usually taxable (unless the DRP is in an IRA, which is a different matter).
You need to keep good records. Keep all your statements together and use a good spreadsheet program or accounting program if you plan on doing a lot of DRP investing. These records are especially important at tax time, when you have to report any subsequent gains or losses from stock sales.
Because capital gains taxes can be complicated as you sort out short-term versus long-term capital gains on your investments, DRP calculations can be a nightmare without good record-keeping.