What Is Dividend Reinvestment Plan (DRIPs) – Its Types, Benefits, Tax And Disadvantages
Mutual funds are becoming increasingly popular for the vast majority of the Indian population and for a very good reason. According to a survey, over 40% of the respondents stated their intentions to invest in equity and mutual funds in the near future.
If you’re looking for sheer growth and have a high-risk appetite, you have ultra growth funds. If you’re looking for annual cash inflows, you have debt and dividend funds that will take care of your needs.
However, if you’re looking for lower-risk investments (when compared to ultra-growth funds) while taking full advantage of the power of compounding, then Dividend Reinvestment Plan (DRIP) is made just for you.
Dividend Reinvestment Plans
Dividend Reinvestment Plans, commonly abbreviated as DRIP, allow you to automatically reinvest proceeds from dividends into additional shares of the company/units of the mutual funds. Usually, there will be a hard limit on how many shares can be purchased in each transaction. This allows shareholders to utilize the power of compounding, by accumulating additional shares over time (which in turn will generate dividends, which can be reinvested).
Usually, when dividends are paid out, shareholders receive that money in their bank accounts as direct deposits, or in their brokerage accounts as the case may be.
However, in the case of DRIPS, the money will be automatically converted into additional shares of the company. Sometimes, these additional shares may even be issued at a nominal price/discounted price (when compared to the market value).
These plans are particularly common with shares that offer a high dividend yield.
Types Of Dividend Reinvestment Plans
There are four major types of DRIPs that are commonly available to the investing public.
- Direct DRIP: Dividend Reinvestment Plans offered directly by the company.
- Third-Party DRIP: Dividend Reinvestment Plans offered by third-parties, usually in exchange for a commission
- Mandatory DRIP: DRIPs that make it mandatory for the dividends to be reinvested in the form of shares.
- Optional DRIP: Dividend Reinvestment Plans that allow the shareholders to re-invest, only at their own discretion.
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Benefits Of Dividend Reinvestment Plans
Here are some benefits of Dividend Reinvestment Plans as a shareholder:
- Invest Without Commission
The additional shares that a shareholder purchases through the dividend reinvestment plans are usually not subject to a brokerage/commission. Transaction costs can be saved when participating in a Dividend Reinvestment Plan. - Purchase At A Discount
Most companies tend to offer additional shares, at a discounted price when compared to the current market price. Usually, there are no set lock-in periods as well. Even if you’re not looking to reinvest in a company, the potential for arbitrage opportunities is high. - Take Full Advantage Of The Compounding Effect
Not only is your base investment’s market value appreciating over time, but you can also invest in additional shares through the excess income received, creating a huge compounding effect. Over years, the returns from a Dividend Reinvestment Plan can snowball, allowing your investment to see significant returns. - Company Growth
The money that’s reinvested can be used by the company to fuel further growth, which will in turn be reflected by the market value of the shares.
Disadvantages Of Dividend Reinvestment Plans
On the flip side, Dividend Reinvestment Plans come with their own share of negatives as well:
- Limitation Of Voting Rights
If you’re interested in taking an active part in the management of the company, DRIPs are not the way to go forward, as they tend to limit the voting rights of such shares. - Dilution Of Shares
For all non-participants of DRIPs, their shareholding will get diluted over time, as additional shares become outstanding in the market. - No Control Over Share Price
When participating in a DRIP, you have no control over how much the stock is priced. You can easily end up purchasing shares when the market is overvalued. - Not Suitable For Short Term Investors
As DRIP triggers either annually/semi-annually, depending on how often the company declares dividends, it does not make sense for short-term investors to wait around for the dividends to be announced to purchase new shares. - Lack Of Diversification
A DRIP increases your exposure to the same company. Constant rebalancing of your portfolio is required, else you might run the risk of putting all your eggs in a single basket.
Tax On Dividend Reinvestment Plans
Usually, when you stay invested and do not liquidate your investments, you won’t be subject to any taxes. Typically, these gains that you’d make on paper would be called “unrealized capital gains”, and as such wouldn’t attract any taxes.
However, with Dividend Reinvestment Plans the tax treatment differs.
Tax treatment of DRIPs is similar to when you actually receive your dividends in the form of cash through your brokerage account. It will be subject to a Dividend Distribution Tax of 15%. The company will deduct 15% before distributing the dividends.
Instead of getting the money, and then reinvesting the money into the same company, you’re directing the company to keep the money in lieu of shares.
Final Word
Like any other investment instrument, Dividend Reinvestment Plans also come with their own share of positives and negatives. Ensure that you conduct your own research, understand all the risks and benefits involved and invest only when you’re absolutely satisfied with the instrument.
For more information about investments, particularly in Mutual Funds, visit the Navi Mutual Fund. We’ve taken it upon ourselves to build a knowledge base, that will help investors to make informed investment decisions for themselves.
Disclaimer: Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing.
FAQs
Ans: The Cost of acquisition of your initial purchase is the amount you originally invested. Further acquisition through DRIPs will be made at the discounted price/market value, as offered by the company.
Ans: Yes, several mutual funds players do offer Dividend Reinvestment plans. The amount of the dividend supposed to be distributed to individual investors is used by the AMC to purchase additional shares, at their discretion. Works extremely similar to a direct, mandatory dividend reinvestment plan offered by a company.
Ans: Each purchase of shares will be treated as a separate transaction, for the purpose of taxation. If your period of holding is more than one year, you will attract only the reduced rates of Long Term Capital Gain. However, if any of your recent Dividend repurchases happened within the last 365 days, to that extent, you will be eligible to pay the 15% rate of Short Term Capital Gain.
Ans: Gains from liquidating your investments – Income from Capital Gains.
Dividend income, (for companies which are not liable to pay Dividend Distribution Tax), – Income From Other Sources
Ans: Conduct your own research, and come to a logical conclusion based on your financial situation.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
