Dividend Reinvestment Plan (DRIP)

A dividend reinvestment plan is an arrangement under which the cash a security distributes is used automatically to buy more of that security rather than paid out. The SEC describes such plans as allowing you "to buy more shares of a stock you already own by reinvesting dividend payments into the company." The purchases happen without any instruction from you, are usually made in fractional amounts so that the whole distribution is invested, and continue until you switch the arrangement off.

The label covers two things that behave differently, and it is worth knowing which one you have. A company-run plan, often administered by the company's transfer agent and sometimes called a direct stock plan, buys shares from or through the company itself. A brokerage reinvestment election is a setting your broker applies to a position in your account, buying in the open market. Both produce the same tax result. They differ in what you can control, which is the subject of the SEC's main caution about the first kind.

One further point of vocabulary: the same election usually applies to any distribution from a fund, not only to dividends. That includes a capital gains distribution, which is not a dividend at all despite arriving the same way and being reinvested by the same setting.

Reinvesting changes nothing about when the tax is due, and this is the single most common surprise. A distribution paid in a taxable account is reportable income in the year it is paid, whether it arrives as cash or is immediately spent on more shares. IRS Publication 550 makes the point directly about these plans: where dividends are used to buy more stock at fair market value, the dividends are still reported as income. The practical consequence is that the tax has to be paid from somewhere else, because the money that would have paid it has already been reinvested. On a small position this is trivial. On a large one held for income, it means a tax bill arriving each year against a holding that has produced no spendable cash.

Every reinvestment is a purchase, and that is the fact with the longest tail. Each one buys shares at that day's price, so it has its own cost basis and its own holding period, and it is a separate tax lot from every other purchase in the same position. A position held for ten years with quarterly distributions contains forty-one lots. Three consequences follow, and none of them is obvious from a statement showing a single line.

First, the basis of the position grows every time a distribution is reinvested, and those additions are what prevent the same dollars being taxed twice, once as distribution income and again as capital gain at sale. Forgetting them is the classic and expensive basis error, and the details of it belong with cost basis rather than here. Brokers have reported basis to the IRS for dividend reinvestment plan shares acquired since the start of 2012, so the exposure is concentrated in positions older than that.

Second, holding periods inside the position are staggered. Shares bought by a reinvestment last month have been held for a month, however long you have owned the rest. Selling the whole position after many years therefore usually produces a mostly long-term gain with a small short-term slice attached, and selling a part of it makes the choice of which lot you are selling matter.

Third, an automatic purchase is still a purchase for the purposes of the wash sale rule, so a reinvestment landing within the 61-day window around a sale at a loss can disallow part of that loss without anyone deciding anything. This is a well-documented trap and it is covered where it belongs, on the pages for the wash sale rule and for tax-loss harvesting.

The company-run version has a trade-off the brokerage version does not. The SEC's caution about direct plans is that they "usually will not allow you to buy or sell shares at a specific market price or at a specific time," and that instead "the company will buy or sell shares for the plan at set times, such as daily, weekly, or monthly, and at an average market price." So you give up control of execution in exchange for the automation. The SEC also advises checking with the company or your brokerage firm about whether the service carries a charge, which varies by plan.

In a tax-advantaged account the entire tax discussion above falls away. Distributions inside an IRA or a workplace plan are not reported as income when they occur, basis in individual lots does no work, and the wash sale rule has nothing to disallow. What remains is the ordinary argument for automation, which is that the cash gets invested rather than sitting idle, and the ordinary argument against it, which is that the reinvestment buys more of what you already hold regardless of whether that is where the money should go.

You elect reinvestment, either with the company's plan administrator or as a setting on the holding in your brokerage account. On each payment date the cash that would have been distributed is used to buy additional shares, including fractional shares so that the full amount is invested. The purchase is recorded as a new lot at that day's price. At year end the payer still reports the distribution on Form 1099-DIV as though it had been paid to you, because for tax purposes it was.

A hypothetical example of one reinvestment. Marcus owns 400 shares and the company declares a quarterly dividend of $0.55 a share, so his distribution is $220 (400 × $0.55). On the payment date the shares trade at $44.00, and the plan uses the whole $220 to buy 5 shares ($220 ÷ $44.00).

He now owns 405 shares. No cash reached him, and he must nonetheless report $220 of dividend income for the year. The 5 new shares have a cost basis of $220 and a holding period that begins that day, so if he sold the whole position two months later, those 5 shares would produce a short-term result while the original 400 might not.

Repeat that four times a year for a decade and the position contains forty-one lots and has accumulated basis of the original purchase plus every reinvested dollar. That accumulated basis is the reason a long-running plan makes the eventual sale cheaper in tax than the raw sale price suggests, and the reason the annual statements are worth keeping.

Pros

• The cash is invested immediately and completely, including fractional amounts, so nothing sits idle waiting for a decision.
• It removes a recurring decision, which is useful precisely because the amounts are individually small enough to be neglected.
• Reinvested amounts add to your basis, reducing the taxable gain when the position is eventually sold.
• Inside a tax-advantaged account it is close to costless, since none of the tax and lot consequences apply.

Cons

• In a taxable account the tax is due in the year of the distribution even though no cash arrived to pay it.
• Every reinvestment creates a new lot, which multiplies record-keeping and complicates a partial sale.
• Automatic purchases can trigger the wash sale rule around a sale at a loss without any deliberate act.
• It concentrates further into a holding you already own, which works against rebalancing and can quietly increase concentration over years.
• Company-run plans generally do not let you choose the price or the timing of the purchase.