Why You Should DRIP Your Dividends

A dividend reinvestment plan, or DRIP, is an important tool that every long-term investor should be aware of. Not only can automatic dividend reinvestment make your life easier, but enrolling in a DRIP can maximize the long-term effects of compound gains, and result in a nest egg that is thousands of dollars more than it otherwise would have been.

What is a DRIP?

A DRIP stands for dividend reinvestment plan, and is basically a way to automatically buy more shares of your stocks when dividends are received. In other words, when one of your stocks pays a dividend, instead of receiving a check, or cash appearing in your brokerage account, the dividend is automatically used to buy additional shares of that stock.

Why is dividend reinvestment so important?

The importance of reinvesting your dividends is best illustrated with a real-world example, and I'll use one of my stocks, Realty Income (NYSE: O).

Let's say that you decided to invest $10,000 in Realty Income when it first listed on the NYSE in 1994. If you had simply collected cash dividends over the years, your shares would have appreciated by 590% by mid-2017, for a total value of $69,000. In addition, you would have collected a little more than $44,000 in dividends along the way, for a total of $113,000. Not bad for a $10,000 investment.

On the other hand, if you had reinvested all of your dividends, your $10,000 investment would have compounded to a staggering $307,500. In other words, by reinvesting your dividends instead of simply collecting the dividends in cash, your investment would have generated nearly three times the total return.

Advantages of a DRIP

As you can see, reinvesting your dividends is crucial to achieving the highest possible total return from your investments. However, a natural question is "why can't I just use my dividends to buy more shares of the stock myself?"

There are two major benefits to using a DRIP. One is that you'll avoid trading commissions on your reinvested dividends. Sure, commissions have gotten significantly cheaper over the years, but a $6.99 commission is a big price to pay if you want to invest, say, a $50 dividend payment from one of your stocks.

Second, a DRIP allows you to buy fractional shares of a stock and put 100% of your dividend to work right away. For example, another stock in my portfolio, Qualcomm, trades for about $53 per share as I write this. If your Qualcomm investment generated a $100 dividend payment, you could only afford to buy one share, under normal circumstances. However, a DRIP will allow you to invest all $100 and buy 1.89 shares. Over time, this can make a big difference.

Disadvantages of a DRIP

This isn't to say that a DRIP is without its drawbacks. For one thing, you don't have a choice in how your dividends get invested. If a certain stock is trading for a very cheap price, you won't be able to use dividends from other DRIP-enrolled stocks to invest in it.

There could also be out-of-pocket tax implications for using a DRIP in a taxable brokerage account. Even if your dividend is automatically reinvested, it is still considered to be a cash payment, and therefore can be taxable. And since all of your dividend is being reinvested, you may need to pay the IRS out of pocket for any taxes you owe on your dividends.

The Foolish bottom line

While a DRIP isn't perfect in every way, the advantages certainly outweigh the drawbacks. A DRIP can help you maximize your long-term investing returns, while automating the process and making your life a little easier. I strongly suggest that you enroll all of your dividend-paying stocks in a DRIP, and let the magic of compounding create wealth for you.

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Matthew Frankel owns shares of Qualcomm and Realty Income. The Motley Fool owns shares of Qualcomm. The Motley Fool has a disclosure policy.