Dividend Reinvestment

Dividend reinvestment is the practice of using the cash dividends or distributions paid by an investment to buy more units of the same investment, instead of taking the money as cash. It is offered in three main ways: dividend reinvestment plans (DRIPs) run by listed companies, reinvestment programmes run by brokers, and the reinvestment option on a mutual fund account, under which distributions buy new fund shares at net asset value.

Reinvesting lets income earn further income, the same effect that drives compound interest on a savings account. It does not avoid tax in an ordinary taxable account: reinvested dividends are generally taxed as if they had been received in cash. Some funds go a step further and reinvest income inside the fund itself, through accumulation share classes in the UK and Europe or the "reinvestment" variant of the income option on Indian mutual funds.

Picture an apple orchard. Each autumn the trees produce fruit you can sell for cash. Instead of spending that cash, you use it to plant a few more trees. Next year you have more trees, so more fruit, so you can plant even more. Over many years the orchard grows faster than if you had only planted with money from your own pocket.

Reinvesting dividends works the same way. Each payment buys a few more shares, those shares earn their own dividends, and the holding snowballs. The catch is that you are not spending the fruit, and you still owe tax on it as if you had sold it.

A company DRIP is usually administered by the company's transfer agent. Enrolled shareholders have their dividends used to buy additional shares, including fractional shares, on each payment date. Many plans also accept optional cash purchases, and some are combined with a direct stock purchase plan that lets new investors buy their first shares straight from the company. Some issuers fund their plans with newly issued shares and offer a small discount to the market price; others buy existing shares in the market. Plans may charge enrolment, purchase or sale fees, and the terms are set out in the plan document.

Most brokers now offer their own reinvestment service, sometimes called a synthetic DRIP, for shares and ETFs held in a brokerage account. The broker buys shares at the market price shortly after the payment date, usually without commission, and credits fractional shares where its platform supports them.

When opening a mutual fund account, an investor chooses what happens to income dividends and capital gains distributions: reinvest both, take both in cash, or reinvest one and take the other. Reinvested distributions buy new fund shares at the NAV calculated on the reinvestment date, which is usually the fund's ex-dividend date or payment date. Because the fund's NAV falls by the amount distributed on the ex-date, a holder who reinvests ends up with more shares at a lower NAV and the same total value before tax.

Most funds that charge a front-end sales charge do not apply it to reinvested distributions; the fund's prospectus sets out the exact terms. Two related arrangements exist outside the United States:

• Accumulation share classes. UK and other European funds, including UCITS ETFs, often issue "Acc" classes that retain income and add it to the fund's value instead of paying it out, alongside "Inc" classes that distribute it. This is one of the share class choices a fund may offer.
• IDCW reinvestment in India. Since 1 April 2021 the Securities and Exchange Board of India has required mutual funds to rename the "dividend" option as Income Distribution cum Capital Withdrawal (IDCW), with payout and reinvestment variants, to make clear that such payments can come partly out of the investor's own capital.

The number of shares after one reinvested payment is:

• $N_0$ is the number of shares held before the payment.
• $D$ is the dividend per share.
• $P$ is the price at which the dividend is reinvested.

An investor with 100 shares receives an annual dividend of 2 per share and reinvests at a price of 50. The 200 of cash buys 4 shares, so $N_1 = 100 + 200 \div 50 = 104$. If the dividend and price stay the same, the next payment is 208, buying 4.16 shares. After ten years the holding grows to about 148 shares, compared with 100 for an investor who took the cash. This steady buying at whatever the price is on each payment date has an effect similar to dollar cost averaging and to a systematic investment plan.

In the United States, the Internal Revenue Service treats reinvested dividends as income in the year they are paid, reported on Form 1099-DIV, even though no cash was received. If a DRIP lets members buy shares below fair market value, the IRS also treats the discount as dividend income. Each reinvestment creates a new purchase lot with its own cost basis, which must be added to the investor's basis to avoid paying tax twice when the shares are sold. Since 2012 brokers and fund companies have been required to track and report the cost basis of shares acquired through dividend reinvestment, and mutual fund holders may use the average-cost method. Inside an individual retirement account or other tax-advantaged account, reinvested dividends are not taxed when paid.

In the UK, income retained in accumulation units of a fund held outside an ISA is still taxable as a "notional distribution". Reinvestment also has practical trade-offs: it can concentrate a portfolio in its largest income payers and work against diversification, and it suits a long-term investment strategy better than a need for regular cash income.

• Internal Revenue Service: Publication 550, Investment Income and Expenses
• Internal Revenue Service: Topic no. 404, Dividends