DRIPs (Dividend Re-Investment Plans) and cash option plans are cost-effective and convenient ways of building your holdings in the companies that offer them. The benefits of DRIPs are substantial. But you should be aware of some minor drawbacks.
There are at least three valid drawbacks of DRIPs (or Dividend Re-Investment Plans). First, they cut your cash flow. Second, you may face income taxes on dividends without receiving the cash. Third, the dividend gross up can reduce or eliminate means-tested benefits.
The three valid drawbacks of DRIPs
If you live off your dividends, or if your cash flow is constrained, you may find DRIPs unsuitable. That’s because DRIPs restrain your cash flow. But if you have extra cash flow, then it’s worth enrolling in DRIPs. The fact is, they remain a great way to build your wealth.
A second drawback is that DRIPs can increase your income taxes. In taxable accounts, when a company reinvests your dividends into new shares, you face income taxes, just as if you had received a cash dividend. The fact is, if you reinvest dividends in many DRIPs, you’ll likely face a large tax bill without the cash to help you pay these taxes. The Canadian dividend tax credit only partly offsets the tax department’s bite. This criticism does not apply to DRIPs in tax-sheltered accounts such as TFSAs (Tax Free Savings Accounts), RRSPs (Registered Retirement Savings Plans) and RRIFs (Registered Retirement Income Funds), if they let you make use of DRIPs at all.
A third drawback of DRIPs is that grossed-up dividends can raise seniors’ reported income. This can reduce or eliminate their means-tested benefits, such as Old Age Security and the Guaranteed Income Supplement.
A fourth, false, drawback of DRIPs is that they lead to an ‘administrative nightmare’. In fact, you can avoid this problem if you use this simple method.
You’ll need to keep track of the adjusted-cost base (or average cost) of your shares. That’s because you’ll need to calculate your gains or losses for tax purposes when you sell. But such record-keeping is easy with our simple method, which we outline below. It should take you just a few minutes to update your adjusted-cost-bases. This is time well spent when you consider the advantages of DRIPs.
Record six pieces of information
Each time a company reinvests your dividends into new shares (or you send a cheque to buy more), the transfer agent will send you an information form. Create this simple six-column spreadsheet to record that information.
In the first column, enter the date on which the company reinvested your dividends. In the second column, enter the dollar amount of each dividend.
In the third column, enter your total dollar investment to date. That is, keep a running total by adding up the dollar amounts of your initial investment and the reinvested dividends from column two.
Say your first reinvested dividend is for $25. Add that to your initial purchase cost in the third column. Three months later, the company reinvests your second dividend of $25.15 into new shares (the extra 15 cents is the dividend on your first reinvested dividend). You add $25.15 for a total dollar re-investment of $50.15. Every time thereafter, just add the reinvested dividends to the total. Dividend increases will add to the dollar value, or course.
In the fourth column, enter the initial number of shares that you bought and the number of new shares that you receive from each reinvested dividend. In the fifth column, keep a running total of the number of shares that you own.
Finally, in the sixth column, divide your total dollar investment to date (column three) by the total number of shares to date (column five). This average price is your up-to-date adjusted-cost base.
When you buy shares through a cash option plan or in the market, calculate your adjusted-cost bases in the same way. When you sell shares, the adjusted-cost base of your remaining shares is unchanged.
Our method is easy and takes just a few minutes. It lets you remain on top of the paperwork.
The Investment Reporter, MPL Communications Inc.
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