A dividend reinvestment plan offers shareholders the opportunity to repurchase new fully paid ordinary shares in a company, rather than take their dividend payment as cash.
One of the main benefits is that additional shares purchased through the plan are generally offered at a discount to the market price. This discount normally works out between two to five percent but can be as much as ten percent.
Another advantage is that shareholders don't have to pay brokerage when reinvesting their dividends. That means you can build up your stake in a company at no additional cost.
As an example, say you owned 1,000 shares in a company which recently paid an interim dividend of 79 cents per share. The shares are valued at $25 each and are offered at a five percent discount in the dividend reinvestment plan. So you could take $790 in cash, or you could increase your stake in the company by 33 shares (The dividend payment of $790 being divided by the discount price of $23.75). The next time the company pays a dividend, you will receive a further 33 allotments of that dividend (taking your total dividend allotments to 1033), further increasing your holding in the company and indirectly forcing you to save.
The downside however is that you need to be diligent with your records, so that you can accurately calculate capital gains tax when your shares are eventually sold.
For example, say you were holding a particular share with a dividend reinvestment plan for 20 years and that company paid dividends twice a year. That means you would have 40 separate transactions that you would need to keep records of for capital gains tax purposes.
Another thing to consider is whether or not you think your stock is overvalued. If so, it is probably not feasible reinvesting back into that company, as it may make more sense to take the cash payment and buy shares in another company, thereby diversifying your portfolio.
As with all investing options, it is important to consider your own position when deciding whether or not to participate in a dividend reinvestment plan. If you won't notice the dividend payment or are likely to blow the cash on a spending spree, it can be a great way of boosting your portfolio and getting compounding to work in your favour. However if the cost of keeping tax records on all your reinvestments is going to be prohibitive, or you think your stock is overvalued, then perhaps you should avoid reinvesting. Essentially, a dividend reinvestment plan is a low cost way of buying more stock.
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