Why you should avoid DRIPs in taxable accounts

Last week’s post about calculating your adjusted cost base with ETFs drew some interesting comments. It’s clear that many DIY investors who use non-registered accounts were unaware of how much work is involved in accurately reporting capital gains.

Careful record-keeping is an unavoidable burden for taxable investors, but you don’t need to make it any more difficult that necessary. Yet as one reader pointed out (hat tip to Jas), some investors complicate their lives by using dividend reinvestment plans in non-registered accounts.

DRIPs allow you to receive ETF distributions—whether stock dividends, bond interest, or return of capital—in the form of new shares rather than cash. You can only receive whole shares, so if the ETF is trading at $20 and you’re eligible for $87 in distributions, you’ll receive four new shares plus $7 in cash. These plans are extremely popular with do-it-yourself investors, and they can be beneficial, since you pay no trading commissions on the new shares and your money starts compounding immediately rather than sitting idly in your account.

But although they are convenient in RRSPs and TFSAs, dividend reinvestment plans are usually not a good idea in taxable accounts. That’s because reinvested dividends must be added to the cost base of your ETFs, as Justin Bender and I explain in our white paper, As Easy As ACB (see page 9, Step 4).

Well, technically, you don’t have to increase your adjusted cost base to account for reinvested dividends. But if you don’t, you’ll pay more tax than necessary when you eventually sell the ETF shares. If you’re a long-term investor, that additional tax bill can be enormous.

The additional record-keeping caused by DRIPs was cumbersome enough when funds paid distributions quarterly or annually. But these days many ETFs make monthly payouts, which means you’ll be making 12 entries a year for every ETF that has a dividend reinvestment plan. That’s a lot of paperwork for a dubious benefit. It typically makes more sense to take your distributions in cash and add use them to purchase new shares whenever you add new money or rebalance your portfolio.

A final note: Some readers asked exactly how capital gains and losses should be reported to the Canada Revenue Agency. The CRA has produced a document called Tax Treatment of Mutual Funds for Individuals that should answer those questions. Remember to always consult an accountant or other qualified tax expert if you need specific advice.