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You may decide that it’s better to receive dividend distributions in cash, especially if you plan to use them for TFSA contributions, or to help fund living expenses.
Q. What are the pros and cons of using a DRIP in an unregistered account?
–Doug
A. Many stocks and exchange-traded funds offer a dividend reinvestment plan, or DRIP, for investors. A dividend reinvestment plan does just what its name suggests: It reinvests dividends paid by a mutual fund, stock or ETF into more shares or units of that same mutual fund, stock or ETF.
If you have an investment advisor, they can determine which securities are DRIP-eligible. RBC Direct Investing provides a list of Canadian and U.S. stocks and ETFs that are DRIP-eligible, and that should apply for most do-it-yourself investors at other brokerages as well. Mutual funds generally reinvest all distributions into new units as a matter of course.
There are pros and cons to dividend reinvestment plans, Doug, as you suggest. Here are the top three reasons to DRIP and not to DRIP.
The magic of compounding is one of the definite pros of dividend reinvestment. If you own $100 worth of a stock that grows at 4% per year and pays a 2% dividend, and you reinvest your dividends, you will have $179 after 10 years. If you do not reinvest, you will have only $148 in the stock (though you will have received $24 of dividends in cash, so $172 in total).
Another benefit is that at least some of your investment decision making is automatic, as your cash dividends are automatically invested into a stock or ETF you liked enough to buy in the first place, and like enough to continue to own. Procrastination can be a major investment hurdle, and automatically reinvesting dividends into more shares of a security can help reduce that procrastination. Otherwise, investors often end up with large cash balances that accumulate over time.
If you work with a transactional investment advisor, or you are a do-it-yourself investor, reinvesting cash comes with a cost—commissions. So, another pro for a DRIP strategy, Doug, is to reduce transaction costs that reduce your returns. Even if you work with a fee-based investment advisor, it is not uncommon for cash to go uninvested in segregated accounts if they are not monitoring cash accumulation closely.
There can be some negatives to DRIP accounts—so in fairness, we should consider them too.
One of the main drawbacks, Doug, is the implications for calculating your adjusted cost base. When you buy an investment in a non-registered account, the eventual sale proceeds need to be reported on your tax return. The sale will generate either a capital gain (profit) or a capital loss (loss). If you have reinvested dividends, your adjusted cost base is not simply the original purchase price, but also the reinvested dividends, and these must be considered and added.
With a foreign security, like a U.S. stock, for instance, it gets even trickier. The adjusted cost base needs to be determined in Canadian dollars based on the exchange rate at the time of all additions to the security. In other words, every reinvested dividend will happen at a different foreign exchange rate, and all those reinvested dividends need to be calculated in Canadian dollars.
Another con for DRIP investors is that calculating your investment return for a security or even an account may not be so simple. This may not matter to some people, but when you look at your book value for an investment or for an entire account, it should reflect your original purchase plus any reinvested dividends. That means a comparison your book value to your market value on a statement will not be a true reflection of your return, given your book value will continue to move higher over time with dividends.
The final and most obvious situation in which you might think twice about using a DRIP in a non-registered account is if you need cash from time to time for Tax-Free Savings Account contributions or simply for living expenses, like in retirement. Reinvesting dividends and then having to sell securities over time may not be as efficient as simply allowing cash to accumulate on some or all your securities to provide for needed withdrawals.
A DRIP can be useful in some instances, Doug, but there are also reasons not to reinvest dividends. Decide for yourself what works best, and consider which securities and which accounts are best suited to DRIP, and which are better to receive dividend distributions in cash.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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Another reason to choose not to DRIP is that it leaves you have the flexibility to allocate that accumulated cash to better balance your portfolio and add to other positions while they are in a dip, rather than keep adding to the same stock which may be a higher price. I think this is a very important point.
The thing is dollar-cost averaging outways the potential for buying at higher prices, keep investing in the S and P 500 for 20 years using DRIP (which sometimes allows you to buy shares at a lower value than the market). Compound on the compound and manually 8 to 10% over the long term every year and you’re set.