12 ways DRIPs help build your wealth—but mind your taxes

Dividend Re-Investment Plans, or “DRIPs,” can assist you in building your wealth. You can instruct companies with DRIPs to reinvest your dividends into new shares. You can build your wealth even faster when DRIPs are accompanied with cash option plans. That’s where you write a cheque to buy more shares. DRIPs offer you a dozen benefits.

One is that DRIPs let you buy stocks gradually. Having modest dividends automatically reinvested is easier on the nerves than investing big sums all at once–especially during stock market setbacks.

DRIPs give you dollar-cost averaging

Second, DRIPs let you profit from today’s stock market volatility. You profit from what’s known as “dollar-cost averaging”: that is, regularly invest fixed sums and you buy more shares when prices are lower and fewer shares when prices are higher. As a result, you buy your shares at below-average prices.

Third, DRIPs in Canada cut your brokerage fees. Such is not always the case with U.S. DRIPs.

Fourth, you avoid bid-ask spreads (paying the higher “ask” price and taking the lower “bid” price).

Fifth, cash option plans help you resist the risky and futile strategy of “market timing” (trying to buy at the bottom and sell at the top—at the “right time”).

Most companies that offer DRIPs are of high quality

Sixth, most companies and real estate investment trusts (or “REITs”) with DRIPs are of high quality. In fact, at our sister publication, The Investment Reporter, we rate 58 of 72 we cover as either “Very Conservative” or “Conservative.” And 42 are among the elite group that makes up our “Key stock” list.

Seventh, dividend-payers keep you out of scams. Rising dividends improve your chances of making share price gains as well as rising income. As aging investors seek income, they’re likely to bid up the prices of stocks that raise their dividends.

Eighth, DRIPs give you compounding. As your reinvested dividends buy more shares, your dividends get bigger. And all of your dividends work for you. One study found that a dollar invested in the U.S. stock market from 1926 to the millennium grew to $105.96 from capital gains. Reinvest the dividends, however, and that dollar grew to $2,591.79.

Ninth, DRIPs put your dividends to work immediately. This beats letting them sit idly in your account.

Tenth, DRIPs amount to “forced” savings plans: you can’t spend dividends you don’t receive.

Eleventh, the dividend tax credit on Canadian stocks reduces the tax department’s bite. But interest income is fully taxed outside of registered accounts.

A twelfth benefit is that 33 of the Canadian investments that The Investment Reporter covers will reinvest your dividends into new shares at a discount to their market prices. So you profit right from the start.

Some caveats

If you need dividends or your cash flow is constrained, you may find DRIPs unsuitable. That’s because DRIPs reduce your cash flow. But if you have extra cash flow, then it’s worth enrolling in DRIPs. They remain a great way to build your wealth.

It’s worth noting, though, that DRIPs can expose you to income taxes. In taxable accounts, when a firm reinvests your dividends into new shares, you face income taxes just as if you had received a cash dividend. If you reinvest dividends in many DRIPs, you’ll likely face a large tax bill without the cash to help you cover these taxes. The Canadian dividend tax credit only partly offsets the tax department’s bite.

This criticism applies to DRIPs in taxable accounts—but not in tax-sheltered accounts such as Tax-Free Savings Accounts (TFSAs), Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs).

Another caveat: unsheltered grossed-up dividends can raise seniors’ reported income. This, in turn, can subject them to the Old Age Security claw back.

 

The TaxLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846