What Is a DRIP? How Dividend Reinvestment Works (and How to Set One Up)

If you own dividend stocks, at some point your broker will ask what to do with the cash: keep it, or put it back to work. A dividend reinvestment plan, or DRIP, is the second choice made automatic. It is one of the simplest tools in dividend investing, and it is worth understanding before you switch it on, because it affects your share count, your taxes, and even your ability to claim a loss.

How a DRIP works, step by step

1. A dividend is paid. Your broker receives the cash on your behalf on the payment date.
2. The cash buys more shares. Instead of sitting in your account, the dividend is used to buy more of the same stock or fund at the market price.
3. Fractions are included. Most large brokerages support fractional shares, so the whole dividend is reinvested even when it is less than one share.
4. Your next dividend is larger. You now own more shares, so the next payment is bigger and buys even more.

For example, suppose you own 100 shares that pay $0.50 each. That is a $50 dividend. If the stock trades at $69, a DRIP with fractional shares buys about 0.72 of a share. A broker that only buys whole shares would buy none and leave the $50 as cash.

Two kinds of DRIPs

There are two ways to reinvest dividends. Most investors use the first.

Company plans can suit someone who wants to build a position in one company gradually and values a possible discount. For most people, the convenience of a single brokerage account outweighs it. Read a plan's documents for its current fees and terms before you enroll.

How to turn on a DRIP

Menus differ between brokerages and change over time, so check your broker's help page for the exact path. The setting usually lives in one of three places:

• When you buy. Some brokerages show a "reinvest dividends" checkbox on the trade screen.
• On your positions page. You can switch reinvestment on or off for each stock or fund you hold.
• In your account settings. Look for a section on dividends and capital gains, where you can choose to reinvest in the security instead of depositing cash to your core account, and often set a default for the whole account.

A few things to check as you do. Settings are usually kept separately for each account, so your IRA and taxable account each need their own. When both an account-wide default and a per-holding setting exist, the per-holding setting usually wins. Some managed accounts, such as robo-advisor accounts, reinvest by default. And stocks, ETFs, and mutual funds are typically eligible while bonds and CDs often are not.

What the growth looks like

Here is the estimator above run for 100 shares bought at $50, paying $0.50 a quarter (a 4% yield), with the share price and the dividend each growing 5% a year:

After 20 years the DRIP path owns about 116 more shares and receives roughly twice the yearly income, while the cash path has collected about $6,600 in dividends along the way. This shows share count and income only, not the total value of each path. Our guide to DRIP vs. taking dividends as cash compares the two on portfolio value. These are illustrations with steady assumptions. Real prices move and dividends can be cut.

What it costs

At major brokerages, turning on dividend reinvestment does not add a commission or fee. You still pay whatever a fund charges in its expense ratio, and reinvesting does not change that. Company-sponsored plans are where fees are most likely, from enrollment charges to per-purchase or sale fees, which can weigh heavily on small amounts. Compare a plan's fee schedule with what your broker charges before enrolling.

Taxes and record keeping

• Reinvested dividends are taxed. In a taxable account you owe tax on dividends in the year they are paid, even though you never saw the cash. Box 1a of Form 1099-DIV includes reinvested dividends. Whether they are taxed at ordinary or qualified rates depends on the dividend, as we explain in our guide to qualified vs. ordinary dividends.
• Each reinvestment is a separate purchase. Every one has its own cost basis, which is the dividend amount that bought it. Brokerages generally track this for you, and it matters when you sell.
• Discounts count as income. If a plan sells you $100 of stock for a $95 dividend because of a 5% discount, you are taxed on $100 of dividends and your basis is also $100.
• Plan for the bill. Because reinvesting leaves no cash to pay the tax, set money aside. The Dividend Tax Calculator can estimate what your reinvested dividends will cost each year.

Why people use a DRIP

• Compounding. More shares means more dividends, which buy more shares.
• It is automatic. You do not have to remember to reinvest, and you avoid the urge to spend the cash.
• No wasted cents. With fractional shares, every dollar of the dividend goes to work.
• Steady buying. You add to your position at regular intervals whatever the price.

When it may make sense to turn a DRIP off

• You need the income. If dividends cover expenses, you want the cash.
• One holding is getting too large. Taking cash lets you invest it elsewhere and keep your mix balanced.
• You plan to sell at a loss. Turn it off first to avoid a wash sale.
• The dividend or the company looks shaky. A DRIP buys at any price, including when things look risky, so review your holdings from time to time.

How to get started

1. Check your broker. Confirm it offers reinvestment on the accounts and holdings you want, and whether it supports fractional shares.
2. Choose your holdings. Decide which investments to reinvest and which to leave as cash.
3. Turn it on in each account. Set it for your taxable account and your IRA separately.
4. Check after the first payment. Confirm the shares were added and the amount looks right.
5. Review once a year. Look at your mix, your taxes, and whether you still want to reinvest. Model different scenarios with the DRIP Calculator or the Compound Interest Calculator.