Reinvesting dividends on your ETFs

Q What is the best way to reinvest dividend distributions on my ETFs? And when and how are reinvested dividends taxed?

— P. Ronaldo, Smiths Falls, Ont.

A One downside of using ETFs rather than mutual funds is that the former do not reinvest dividends and interest payments automatically. Instead, they pay distributions in cash that often sits idle in your account. Mutual funds, by comparison, can reinvest dividends and interest, ensuring every penny goes right back into the fund.

The good news is that ETF investors can set up dividend reinvestment plans (DRIPs) with their online brokerage. These plans allow you to receive dividend and interest payments in the form of new shares instead of cash. You can’t reinvest every cent because you can only receive whole shares with a DRIP, but you can get pretty close.

Here’s how it works. Say you hold 1,000 shares of an ETF trading at $20 and the fund announces a dividend of $0.15 per share. If you took the dividend in cash you would receive $150. But with a DRIP you would get seven new shares (7 x $20 = $140), plus $10 cash. Even better, you won’t pay any commission to acquire those new shares.

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Just about every brokerage allows DRIPs, though they may not offer them for every ETF. Some brokerages allow you to enrol in a DRIP online after you have purchased your initial holding, while others require a phone call.

Now to your second question, which confuses a lot of investors. Reinvesting dividends through a DRIP has zero effect on taxes. Some wishful thinkers believe reinvesting the dividends allows you to defer taxes, but no such luck. If you hold an ETF in a taxable account, you will receive a T-slip every spring that spells out the amount of dividends paid by the fund, and you’ll be taxed annually on that amount, whether or not you have a DRIP in place. (The same is true for mutual funds, by the way.)

There’s another important tax consideration here. If your ETFs are in a non-registered account, DRIPs can make bookkeeping more difficult. Every new share purchased as part of a DRIP will change the adjusted cost base (ACB) of your holding. You need to track your ACB in order to accurately calculate any capital gains or losses when you eventually sell the shares of your ETF. It’s true, your brokerage should do this for you. But in my experience, online brokerages are hit and miss when it comes to accurately tracking ACB. So if you want to save yourself the accounting, forget about DRIPs in taxable accounts and just reinvest the cash dividends once or twice a year.

If you’re worried that forgoing DRIPs means you give up the value of compounding, this isn’t a significant issue. Remember, you’re still reinvesting the dividends—you’re not spending them. The only difference is you’re doing it manually once or twice a year instead of automatically with every monthly or quarterly payment. My colleague Justin Bender compared a DRIP to annually reinvesting cash dividends from a Canadian equity ETF and found that over a 10-year period the difference in returns was negligible.

That said, since the accounting is not an issue in RRSPs and TFSAs, dividend reinvestment plans can be an excellent and hassle-free option in tax-sheltered accounts.

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