Use DRIP for compound interest

In this article, we will talk about what DRIP is, the advantages of using DRIP, tax considerations and how to set up DRIP for your Fidelity investment.

Summary

  • What is DRIP?

  • The advantages of DRIP

  • Tax considerations

  • How to set up DRIP for your Fidelity investment

What is DRIP?

For a lot of stocks and funds, they pay dividends monthly, quarterly, semi-annually or annually. When you receive the dividends, you have the option to pocket the cash, or use the dividends to buy more stocks. 


DRIP stands for dividend reinvestment plan. With DRIP, instead of getting the dividends payout in cash, you will automatically reinvest the dividends into the same companies or mutual funds that issued them. Since each DRIP program is supported by a particular brokerage, the specific details of the program (such as e.g. what securities are eligible for DRIP) will vary. This article presents a general overview of DRIP. For your brokerage’s program, you will need to consult with their documentation.

The advantages of DRIP

If you are using dividends to fuel your retirement or expenses, then getting it paid out regularly in cash is a good idea. However, if you don’t need to use the dividends right away, there are many advantages of setting up DRIP.


  1. You can buy fractional shares with dividend reinvestment

While some brokers don’t have the fractional share purchase option, DRIP allows you to buy fractional shares with the dividend you received, instead of accumulating enough money to buy a whole share.

  1. Reinvestment is automatic

When you signed up for DRIP, the reinvestment will happen automatically, whenever your fund pays out a dividend.

  1. No fees and commissions

Normally DRIP does not charge any fees or commissions for the additional shares you are purchasing with your dividends, while buying the security as part of a separate transaction may involve additional costs.

  1. Compound interest

With DRIP, you get more shares of the company without paying additional money. The more shares you have, the more dividends you are likely to receive, and the more shares you are able to purchase. 


Tax considerations

With DRIP, even though you are not receiving the payment in cash, you still need to pay taxes for the dividends and capital gains.


Furthermore, each individual dividend that results in a stock purchase is considered a separate “lot” with a separate cost basis and acquisition date for tax purposes. When the time comes around to close the position and sell off the stock, you have to calculate profit and loss on each individual lot for your tax return. This can be quite a headache to manage, especially for bond funds that pay out monthly dividends, but since nearly all brokerages compute capital gains in your 1099, this shouldn’t be a problem for most people.


How to set up DRIP for your Fidelity investment

You can follow the link in this Fidelity article to set up DRIP for your investment:

https://www.fidelity.com/customer-service/how-to-dividend-and-cap-gains-distributions


After signing in, you will have the option to update how you want to use the dividends and capital gains for each individual fund. The options are:

  • Reinvest in security

This is DRIP.

  • Deposit to core account

This means it will pay out in cash.


In summary, there are many advantages to using DRIP. It is advisable to set it up if you don’t need to cash out the dividends and capital gains.

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