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What You Should Know About Dividend Reinvestment Plans

Dawn Reiss

In their most basic form, dividend reinvestment plans -- also called DRIPs -- allow investors to purchase shares of stock and reinvest their dividends for additional shares, which compound over time.

"These plans are a terrific way to accumulate larger positions in companies over time," says Robert Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania. "It is a prime vehicle to systematically purchase more and more shares of a stock."

That's because the more shares an investor owns, the more dividends they will receive.

"Think of it like a snowball," says Brannon Lambert, an independent financial advisor at Canvasback Wealth Management in Raleigh, North Carolina. "The larger it grows, the more it feeds itself. The more it feeds itself, the more it grows."

[See: 20 Awesome Dividend Stocks for Guaranteed Income.]

Many investors are unaware of DRIPs and how they work. "I don't think most people understand it," says Adam Torres, CEO of Century City Wealth Management, in Century City, California. "But I also think they don't understand how compound returns work."

As an example, Torres cites an investor who invests an initial $1,000, plus $20 each month.

"If you leave that in investment for 20 years and you're getting an overall annual return -- think dividend or appreciation of the actual investment of 5 percent, which might be low -- but compound that quarterly and that gives a value of $11,000 and you've multiplied your money by more than 10," Torres says. "Over 40 years, that same investment is $38,000."

Years ago, investors would purchase stock directly from the company, like Coca-Cola Co. (ticker: KO), track their stock purchases on a ledger with graph paper and then reinvest it or get a check cut, Torres says.

"I've have people who bring in certificates now to my office that are 50, 60 or 70 years old and when they deposit them they are worth millions," Torres says.

Now, many investors purchase stock through a large custodian such as Vanguard, Fidelity, Charles Schwab or TD Ameritrade. It's more of a feature of an account and many investors have a DRIP on autopilot so reinvesting their dividends is an obvious choice, Torres says.

Another benefit is dollar-cost average, which takes place when an investor purchases a security at a set time regardless of the price.

"In the case of DRIP, you will typically receive a quarterly or yearly dividend which you will automatically reinvest," Torres says. "Because you are not trying to time the price, you will purchase some of the highs and lows in terms of pricing for the investment."

By purchasing in this manner, investors should have an average lower cost per share than if they tried to time the investment, Torres says.

"Target-date funds take the process of rebalancing and making knee-jerk decisions off the table," says Carter Thomas, financial advisor at Abound Wealth Management in Franklin, Tennessee. "You simply choose the date that best matches the goals for your specific investment and allow the fund company to manage the rest."

If you're not looking to buy individual stock, there's a variety of exchange-traded funds and mutual funds focused on paying dividends that will keep investors diversified.

Ryan Bayonnet, a financial advisor with Storey & Associates in North Canton, Ohio, suggests looking at Vanguard High Dividend Yield ETF ( VYM), a fund that tracks the performance of the FTSE High Dividend Yield index and includes companies such as Microsoft Corp. ( MSFT), Exxon Mobil Corp. ( XOM) and Johnson & Johnson ( JNJ).

"VYM is one of the cheapest ways to access a high-dividend fund with a rock-bottom expense ratio of 0.09 percent and has a respectable yield of 2.88 percent," Bayonnet says.

For mutual funds, Bayonnet suggests the Schwab Fundamental International Large Company Index ( SFNNX), a passively managed fund that tracks the Russell Fundamental Developed ex-U.S. Large Company index and has a trailing 12-month yield of 2.8 percent.

[See: 10 ETFs That Pay Sky-High Dividends.]

"This fund is cheap to own compared to its constituents with an expense ratio of 0.35 percent and also has a low barrier to enter the fund with a minimum investment of $100," he says.

The actively managed Vanguard Equity Income Fund ( VEIPX) invests in large U.S. stocks that have high dividend payouts so it "looks to provide a high level of income through dividends, while still pursuing long-term capital growth," Bayonnet says, adding that the fund has a trailing five-month yield of 2.75 percent.

"It is one of the most cost-effective funds to own with an expense ratio of 0.26 percent ($26 per year on a $10,000 investment), but does have a minimum investment of $3,000," he says.

Pimco Income Fund ( PONAX) is one of the highest rated multi-sector bond funds, Bayonnet says, with a five-star Morningstar rating and nearly a 7.28 percent trailing 12-month yield.

"It is a bit more expensive to own with an expense ratio of 0.79 percent, but will allow you to reinvest a large amount of income without taking the same risks that come with a stock fund," he says.

Financial experts say investors can get into trouble if they focus too much on a singular stock and don't stay diversified. "This can be minimized if the investor participates in several DRIP programs on different stocks," says James Liotta, owner and president of Prominence Capital in Beverly Hills, California.

Investors also should be aware of potential stock dilution. If more shares are being issued from the company's treasury stock into the marketplace to cover DRIP, the percentage ownership of nonparticipating shareholders is reduced and earnings are spread over more shares, Liotta says.

Before signing up for an investment account, investors should inquire about DRIPs with their custodian, Thomas says, because most allow investors the option to use a DRIP to invest in ETFs and mutual funds, but it isn't always allowed for individual stocks.

In addition, if investors enter into an automatic dividend reinvestment plan, they usually don't have to pay a brokerage fee, Bayonnet says.

Investors also should consider how DRIPs will affect their taxes.

[See: The 10 Best Dividend Stocks of 2016.]

"While you are reinvesting the dividends, the government still deems the dividends as taxable income to you," Thomas says. "Make sure that you have the outside funds to pay for the taxes so that you aren't forced to sell your investment at an inopportune time. If the DRIP plan is in a tax-advantaged account, no taxes are due on the dividends received."

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