There are many ways to potentially grow your savings faster. You could invest in equities (shares in publicly traded companies); having an investment portfolio that’s diversified to protect against market volatility is always recommended; and there’s a growing range of alternative investments designed to provide high returns.
Another way is to sign up for a dividend reinvestment plan (DRIP). A DRIP is a way to automatically reinvest any dividends that are paid out by companies whose shares you own. However, it’s really important to understand what a DRIP is, how it works, its potential pros and cons, and whether a DRIP makes sense for you. Let’s take a look.
What is a DRIP?
A dividend reinvestment plan is a program that allows you to automatically reinvest the dividends you receive from your investments back into the company's stock.
A dividend is a portion of a company’s earnings that many publicly traded companies pay out to their shareholders. It’s usually represented as a percentage of the value of the shares you hold, with payments made monthly, quarterly, semi-annually or annually, depending on the company. The amount paid out can vary greatly, and some companies don’t pay dividends at all.
Once you’ve chosen a DRIP for your investments, you don't need to manually reinvest your dividends; it’s done automatically for you, making it a convenient and efficient way to grow your investments. DRIPs are often administered by the companies whose shares you own or through brokerage firms.
How do DRIPs work?
With a DRIP, the money a company pays out in dividends is automatically used to buy more shares in the company. This can happen in one of two ways:
- Dividends are automatically used to buy more shares of the same stock. This lets you grow your investment without doing anything.
- If the dividend isn't enough to buy a whole share, you won't miss out. You'll receive a fractional share, valued at the market price on the dividend payment date.
The option to buy fractional shares is a key benefit of DRIPs. You can keep investing your dividends, no matter how small. Over time, these fractions can add up, helping your investment portfolio grow quicker.
How can DRIPs help your savings grow faster?
Compounding helps your savings grow faster by putting both your original investment and the earnings it generates — such as dividends, interest and capital gains — back to work. Each time those earnings are reinvested, they have the potential to generate their own earnings. Over time this “growth on growth” effect can accelerate wealth accumulation.
Let's take a look at an example:
- Samantha buys $10,000 worth of stock in a company that pays out 4% in dividends.
- She reinvests the dividends through a DRIP.
- With an average annual growth in the stock’s value of 7%, her $10,000 investment would be worth $28,394 after 10 years.
- Without reinvesting the dividends, the same investment (with the same conditions) would be worth around $19,672 after 10 years, plus $5,913 received in cash dividends, for a combined value of $25,585.
- This is considerably less than if dividends were reinvested.
By always investing dividends with a DRIP, you get to own more shares and receive increased dividend payments on those shares. This can lead to faster investment growth.
Are reinvested dividends taxable in Canada?
Dividend income received in non-registered accounts is taxable and that includes reinvested dividends. When dividends are paid, they’re considered taxable income in the year they’re received, even if they’re reinvested through a DRIP.
When shares are held in non-registered accounts, dividends from Canadian companies are eligible for the dividend tax credit, which can reduce the effective tax rate on dividend income. It’s important to note that the tax implications of reinvested dividends are the same as those for dividends received in cash.
You can minimize the taxes you pay on dividends by holding your DRIP investments in a registered account. If you held them in a Tax-Free Savings Account (TFSA), your investments would grow completely tax free (other than potentially some withholding tax, if the dividends are from foreign companies), and you wouldn’t be taxed when you make withdrawals either.
If you held them in a Registered Retirement Savings Plan (RRSP), your DRIP assets would grow tax free (you wouldn’t be taxed on any dividend payments as long as they stayed within the RRSP). You would only pay tax on them when you withdraw them (either from the RRSP or from a RRIF).
Is reinvesting dividends a good idea?
While reinvesting dividends through a DRIP can be a good idea for many investors, it can have also some downsides. Let’s take a look at the benefits and disadvantages:
Benefits of a DRIP
- The power of compounding can significantly boost the value of your investments over time.
- DRIPs automate the reinvestment process, making it easy for investors to grow their holdings without having to actively manage them.
- Many DRIPs offer the option to buy shares at a discount, which can be a smart way to lower your overall investment costs.
Disadvantages of a DRIP
- Once dividends are reinvested, they’re no longer available for other uses, like paying bills or investing in other opportunities.
- Reinvesting in a single stock or a limited number of stocks can increase your exposure to market volatility and company-specific risks.
Is a DRIP the right choice for you?
If you're considering a dividend reinvestment plan as part of your investment strategy, you should discuss your options with your IG Advisor. They can help you understand the benefits and risks of DRIPs, analyze how they could fit into your overall financial plan and guide you through the decision-making process.
Talk to your IG Advisor today to discuss whether a DRIP is the right choice for you. If you don't have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Advisor.
Mutual funds and investment products and services are offered through the Mutual Fund Division of IG Wealth Management Inc. (in Quebec, a firm in financial planning). Additional investment products and brokerage services are offered through the Investment Dealer, IG Wealth Management Inc. (in Quebec, a firm in financial planning), a member of the Canadian Investor Protection Fund.
