What Is a Drip? How to Get Started with DRIP Investing In Canada
One of the most popular investment strategies in Canada is buying dividend-paying stocks. Corporations pay dividends to shareholders from the company’s after-tax earnings, allowing investors to share in the company’s profits while generating a reliable income stream. Many Canadian companies have rewarded shareholders with dividends for decades. One of the best ways to take advantage of dividend payments is to reinvest them through a DRIP.
What Is DRIP Investing?
DRIP is an acronym for Dividend Reinvestment Plan. It enables the owners of dividend-paying stocks to purchase new shares from the dividend payments they’ve received. When a DRIP is set up, this is done automatically for the investor.
Benefits of DRIP Investing
There are several advantages to setting up a DRIP with stocks. Here are a few worth considering:
Increasing Compound Returns
Whenever interest earned on an investment is added to the principal amount, you begin earning interest on interest. The phenomenon is known as compounding, and it accelerates the rate at which the value of an investment grows. DRIP plans add investment income (dividends) to your overall holdings, allowing for compounding to occur. You may not notice a difference in the short term, but compounding can add thousands of dollars to your portfolio in the long run.
While the jury is still out on whether dollar-cost averaging is always better than investing large lump sums, it holds many advantages for the average investor. By purchasing shares with DRIP funds, you may buy them at a lower average cost over the long run. More importantly, however, it keeps you focused on “time-in-the-market”, rather than “timing the market.” We all know that trying to pick the best time to buy an investment is a futile effort.
Investing on Auto-Pilot
For most people, when you automate a repetitive task, there’s an increased chance that you will stick to it. DRIP investing automates the process of buying shares. There’s no work involved, and you can focus on the things you enjoy most.
How Drips Benefit Companies
Shareholders are not the only ones who benefit from dividend reinvestment plans (DRIPs). For starters, it increases shareholder capital, giving companies more money to invest towards growth. DRIP investors tend to be more committed as shareholders. If the company has a bad quarter, they are less likely to sell their shares suddenly.
What Are Alternatives to DRIP Investing?
Dividend reinvestment plans are optional. While the benefits are clear, an investor may decide to do other things with the dividend payments they receive. If they have an upcoming purchase, they can cash out their dividends and spend the money on anything they’d like: dinner, vacation, home renovation, etc. In this instance, the investor uses dividends as a source of income, which is a common practice.
Some investors prefer to accumulate their dividend payments in a savings account. They may want to create a future income source or be saving for a significant purchase. Or, they may want to keep the funds on the sidelines while waiting for another investment opportunity.
Another option for dividends is to use the funds to buy shares of a different company’s stock. The reasons for doing this vary, but diversification is certainly one benefit.
How to Set Up a Dividend Reinvestment Plan
A discount brokerage online is the easiest way to set up a dividend reinvestment plan (DRIP). Most online brokers can accommodate DRIP investing, but it’s a good idea to check before opening an account. There are also plenty of online brokers to choose from in Canada. All of the big banks have their brokerages, and there are several independent ones also.
DRIP Investing with Questrade
Questrade is our top-rated discount brokerage here at MapleMoney. We love them for their combination of low fees, including free ETF purchases, robust trading platforms, and excellent customer service. You can set up a DRIP plan with Questrade to manage your cash dividends. To find out more, check out our full Questrade review.
Are Dividend Payments Taxed?
You may be wondering about the tax treatment of dividend payments. In a taxable investment account, dividends are considered taxable income; however, they are more tax-efficient than regular interest income but less efficient than capital gains. You are only taxed on 50% of the profit with a capital gain after selling the investment. Dividends are eligible for a dividend tax credit.
Of course, one way to avoid paying taxes on your investment income is by investing in a government-registered, tax-sheltered account, like an RRSP or a TFSA. In these registered accounts, your investments grow tax-free. With an RRSP, you will pay income tax when you withdraw money from your account, but with a TFSA, you can withdraw funds at any time without any tax implications. You should always consult with an accountant on tax matters. Still, most Canadians are better off maximizing RRSP and TFSA contributions (up to their limit) before they begin contributing to a taxable account.
Dividend Reinvestment: Glossary of Terms
Dividends are the percentage of after-tax profit that a company pays to its shareholders. The company retains remaining profits to invest in future growth. Dividend payments provide regular income for shareholders, regardless of what happens to the share price.
Dividend Reinvestment Plans (DRIPs)
A DRIP is an investment strategy that enables shareholders to reinvest their cash dividends to buy more company shares automatically. DRIPs have many advantages, including increased compound returns and dollar-cost averaging.
Not all individual stocks pay dividends. When a company has a reputation for consistently paying a dividend to shareholders, it becomes a dividend stock. Companies that pay a regular dividend tend to be financially sound while demonstrating consistent earnings and a proven business model. In Canada, we consider the major banks and telecommunications companies to be examples of solid dividend stocks.
Dollar-cost-averaging refers to the practice of purchasing an investment in small amounts regularly instead of less frequent, lump-sum purchases.
Compound interest is “interest on interest.” It occurs when interest earned is added to the original principal amount. Over the long-term, an investment that compounds will grow more quickly, resulting in a higher overall return.
Simple interest is the opposite of compound interest. It occurs when the investment pays interest in the form of cash to the investor. The principal balance does not change and continues to earn interest. While stocks do not earn interest income (they make dividends), it’s similar to a simple interest scenario if you don’t participate in a DRIP.
Final Thoughts on DRIP investing
There comes the point when most investors need to draw income from their stock portfolio. One of the best ways to do this is by having your dividends paid out regularly. But until that time comes, DRIP investing is an excellent way to automate your investments and increase your potential returns. If you haven’t set up a DRIP plan for the stocks you own, now is the time to start!