What is a Dividend Reinvestment Plan?

A Dividend Reinvestment Plan (DRIP) is a plan that allows investors to reinvest their dividends into additional shares or fractional shares. The shareholders receive dividends from the companies periodically. It is a share of the company's revenue which they receive as cash (cash dividends). Companies offer the shareholders to invest that amount to buy more shares of the company on the dividend payment day.

How Does a Dividend Reinvestment Plan Work?

In common practice the shareholders are paid the dividends either by check or the amount gets directly deposited to their bank accounts. The shares offered in a Dividend Reinvestment Plan or DRIP are generally from the company's reserve and are not marketable through stock exchanges. The shareholders use the dividend value to purchase these shares. A dividend is taxable whether received or reinvested. An individual must report the dividend while filing the tax-return even when he does not receive the amount in cash and reinvests it into additional share. A DRIP enables the shareholders to acquire more shares at a lower or discounted price. They do not have to pay the commission for buying the share. Also, companies generally offer a 1% to 10% discount on the market price. Automatic reinvestment compounds the return. As time goes by, one's share increase in the company and that results in more dividends, so in the next quarter, they can buy even more shares with it. This provides an opportunity to earn a greater return in long-term. The shares sold in DRIP are less liquid than share offered in the open market. So, when the stock market declines it is less likely that the shareholders sell these shares. Also, the participants in a DRIP generally aim for a long-term return, thus they do not sell their shares during market volatility. This is one of the reasons the companies prefer the Dividend Reinvestment Plan.