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Recognizing the Disadvantages of Dividend Reinvestment Plans

As with most things in the world of investing, dividend reinvestment plans (DRIPs) have some potential negatives — or at least some points you should consider that counterbalance the many things that make them good investments. Before breaking up with your broker, consider the potential drawbacks.

Buying on the company’s schedule regardless of price

When you reinvest dividends, you get a bargain because you buy the new shares right after prices drop due to the dividend payout, giving you more stock for your dividend dollars. However, you may lose out when the time comes to make other stock purchases. You have no control over the price you pay for optional cash purchases, which occur on the company’s schedule, not yours. A company may choose to sell optional cash purchase plan (OCP) shares once a week, once a month, or even once a quarter. (It’s always the same day, such as the 15th of the month.) If the stock happens to hit an all-time high that day, well, that’s your price.

When you’re buying and selling shares directly through a company, you can’t issue any stop or limit orders. Of course, if you’re investing for the long term, this limitation shouldn’t be a huge issue.

Losing liquidity

When you buy and sell stocks through a broker, you can cash out at any time by calling your broker or logging in to your online account. The trade occurs within minutes, and in a matter of hours or days you can have the money in your checking or savings account.

When buying and selling shares directly through a company, you relinquish that liquidity. You must contact the company or the plan’s transfer agent; obtain, complete, and submit the necessary forms for closing out the DRIP; and then wait for your request to be approved. This process can take a few weeks and may be an available option only once a quarter. You may also incur some fees for closing the account.

Looking out for fees

Although DRIPs are cheap and commission-free, only about half the DRIPs are totally fee-free. As money gets tight, more companies try to quietly slip in fees. As for DSPs, most charge fees, some on every transaction. To protect yourself, read the prospectus to find out what all the fees in the plan are and whether any terms seem unreasonable. Some companies charge $5 for an investment of as little as $25.

Don’t let fees automatically scare you off. If you really like the stock, a direct purchase may still be the more cost-effective way to buy shares.

Paying taxes in a DRIP

Even though you don’t receive a check for all those reinvested dividends, the IRS considers them taxable income. Dividends earned from new shares purchased through a reinvestment plan the previous quarter are taxed as qualified dividends — as in qualified for a lower tax rate. Dividends from new shares purchased through an OCP must meet the holding period requirements to qualify for the lower tax rate.

Keeping detailed records

Though you may get a neat printout from the company’s transfer agent showing all your trades and tallying which dividends and capital gains qualify for reduced tax rates, you may not. Either way, you alone are responsible for keeping track of each purchase, including the date, number of shares purchased, and price paid, so you know exactly how much you owe in taxes when you sell your shares.

Invest in a good spreadsheet program for your computer or purchase a program specifically for managing DRIP accounts.

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