How Do DRIPs Work?

There are some companies that pay a portion of their profits to shareholders. These additional profits are called dividends. They are based on the number of shares you own. So, the more shares you own, the more you receive in dividend income.

A dividend reinvestment plan is one in which the dividends you receive from the company are used to automatically buy more shares. So, instead of receiving a check with your dividend income, the income is used to buy more shares.

If you have been receiving $10 each quarter in dividend income from a company, that money can be used to turn around by more shares. If the companys share price is $40, your dividend income is used to buy 1/4 of a share each quarter. By the time the end of the year rolls around, you have a whole share.

Since dividend payouts are based on the number of shares you own, building up shares automatically in this way means that you will be paid bigger dividends (assuming dividends arent cut) over time. The cycle perpetuates itself, since your bigger dividends allow you to buy more shares, which result in bigger dividends.

DRIPs and Your Retirement Portfolio

DRIPs can be great for use in a retirement portfolio. When you are in the growth stages of building your retirement. you can gain even more with the automatic growth of your portfolio. Each time you are paid a dividend, it is used to buy more shares (or partial shares). You add more to your retirement portfolio, while increasing your dividend pay out.

Another good reason to keep DRIPs in your retirement portfolio is that it can help you reduce your tax liability. You are taxed each year on your dividend income. So, even though your dividends are reinvested, you are still taxed on them as though they were paid to you as a check. Keeping DRIPs in your qualified retirement account prevents you from having to pay taxes on the dividends in the year they are paid.

Keep DRIPs in your 401(k) or IRA (or the Roth version), and you have the advantage of a favored tax status. This helps you put your money to more efficient use on your behalf.

Over time, with the help of DRIPs, your portfolio has the potential to grow at a more rapid pace. You add more shares, and when you are ready to sell at a (hopefully) higher price to fund your retirement, you could see a bigger pay day.

What if Dividends are Cut?

It is important to note, though, that DRIPs arent a sure thing. As with all investments, there are risks to DRIP investing.

First of all, dividends arent guaranteed forever. Companies can decide to cut dividends, or stop paying them out altogether. Its up to the companies to decide whether or not they want to share profits with the shareholders. If things are going badly for a company, it might cut or eliminate the dividend pay out. This will slow down your efforts to build your retirement portfolio.

Many people choose dividend aristocrats  because they are unlikely to cut dividends. In fact, these are companies that have raised their dividends at least once a year, every year, for the past 25 years. While there is a chance that the dividend might be cut, the likelihood is generally lower, since these companies have a long history of raising their dividends, even if its only by a cent.

Additionally, you need to consider that the company itself might lose in value. If a stock price plummets just before you retire, it can be detrimental to your portfolio, even if you have been investing in DRIPs. The reduction in value, plus a dividend cut, can really cause problems. Its important to consider this as you plan your retirement investment strategy.

Overall, though, carefully chosen DRIPs can potentially help bring your portfolio up a notch.