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Q What are the advantages and disadvantages of using DRIP on an unregistered account?
–Doug
ANS. Many publicly traded stocks and funds offer investors a dividend reinvestment plan (DRIP). A dividend reinvestment plan does exactly what its name suggests: it reinvests dividends paid by a mutual fund, stock or ETF into a larger number of shares or units of the same mutual fund, stock or ETF.
If you have an investment advisor, he or she can determine which securities qualify for DRIP. RBC Direct Investments provides a list of Canadian and U.S. stocks and ETFs that are eligible for DRIP and should be applicable to most DIY investors at other brokerages as well. Mutual funds typically reinvest all distributions in new units.
As you suggest, dividend reinvestment plans have advantages and disadvantages. Here are the three most important reasons why it is worth DROP and not DROP.
Reinvestment helps your money grow
The magic of compounding is one of the distinct benefits of dividend reinvestment. If you own $100 worth of stock that grows at 4% a year and pays a 2% dividend, and then reinvests your dividends, you’ll have $179 after 10 years. If you don’t reinvest, you’ll only have $148 in the stock (although you’ll receive $24 in cash dividends, for a total of $172).
Another benefit is that at least some of your investment decisions are made automatically because your cash dividends are automatically invested in the stocks or ETFs that you liked enough to buy and continue to like. Procrastination can be a major investment hurdle, and automatic reinvestment of dividends into more shares of a security can help reduce procrastination. Otherwise, investors often have large cash balances that accumulate over time.
If you work with a transactional investment advisor or are a DIY investor, there are costs to reinvesting your cash – commissions. So another proponent of the DRIP strategy, Doug, is to reduce transaction costs, which reduce returns. Even if you work with a fee-based investment advisor, it is not uncommon for your money to not be invested in segregated accounts unless they closely monitor your cash accumulation.
But be prepared for complicated calculations
DRIP accounts may have some disadvantages – so honestly, we should consider them too.
One of the main drawbacks, Doug, is the implications for calculating the adjusted cost basis. When you buy an investment on an unregistered account, any income from the sale must be reported on your tax return. The sale will result in either a capital gain (profit) or a capital loss (loss). If you reinvested dividends, your adjusted cost basis is not only the original purchase price, but also the reinvested dividends that need to be taken into account and added up.
In the case of a foreign security, such as US stocks, the situation becomes even more difficult. The adjusted cost basis must be determined in Canadian dollars based on the exchange rate prevailing at the time of any additions to the security. In other words, each dividend reinvestment will occur at a different currency exchange rate, and all these dividend reinvestments must be converted in Canadian dollars.
Another disadvantage for DRIP investors is that calculating the return on an investment in a security or even an account may not be that simple. This may not matter to some people, but when you look at the book value of an investment or the entire account, it should reflect the original purchase and any reinvested dividends. This means that comparing book value to market value on your statement will not be a true reflection of your return, given that book value will increase over time with dividends.
The final and most obvious situation in which you may want to think twice about using DRIP on an unregistered account is if you occasionally need cash to deposit into a tax-free savings account or simply to cover living expenses, e.g. retired. Reinvesting dividends and then having to sell the securities over time may not be as effective as simply allowing cash to accumulate in some or all of the securities to provide the necessary distributions.
DRIP can be useful in some cases, Doug, but there are also reasons not to reinvest dividends. Decide for yourself what works best and consider which securities and accounts are best suited for DRIP and which are better suited to receiving cash dividend payments.
Jason Heath is an advisory-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. It does not sell any financial products at all.
