Reap the rewards of compounding

The real power of investment comes from compounding returns – the process of putting your investment income straight back to work so it can earn more income.

To help their investors reap the rewards of compounding, many companies offer dividend reinvestment plans, DRPS.

Under a DRP, investors can choose to use some or all of their dividends to automatically purchase additional shares in a company.

As a sweetener, investors avoid brokerage, and some companies even offer a discount on the share price.

This means that dividend payments are working to earn new dividends rather than languishing in low-interest bank accounts.

Participants in DRPS can also benefit from dips in the market.

When prices are down, a given dividend amount will buy more shares than when prices are high.

However, be aware that it is entirely up to each individual company’s management to decide whether or not it will offer a DRP, and that the plan can be suspended or altered at any time.

Who might DRPS suit?

DRPS are suited to investors who do not need the income and who are seeking to maximise the growth of their portfolio. They can also be good for ‘lazy’ investors.

After the nomination to participate in the DRP is made it happens automatically with each dividend payment: no further action required.

That said, DRPS can generate a lot of paperwork. Each purchase is a separate event with its own cost base for Capital Gains Tax, CGT, purposes, and its own start date for the CGT discount.

DRPS are not suited to retirees and people who are drawing down on their portfolios and dependent on all the income it can produce.

Don’t forget the tax

With a DRP the dividend never hits your bank account, but that doesn’t mean you haven’t earned it.

It still needs to be declared as income on your tax return, along with its associated franking credits – the tax already paid by the company.

Depending on your marginal tax rate, the franking credit might be sufficient to cover any tax payable on the dividend, or you might even receive a refund.

If not, you will need to pay some additional tax, so be prepared for this.

Alternatives to DRPS

DRPS can be good for investors who have a positive view of the company they own shares in and are happy to increase their holding in it.

Of course, if the company turns out to be a dud, partaking in a DRP will magnify the ultimate losses. An alternative is to take cash dividends and regularly apply them to purchasing other assets.

This can still provide the benefit of compounding while creating an opportunity to further diversify and rebalance the portfolio.

Dividend Reinvestment Plans can be an effective part of an investment growth strategy.

The quality of the company offering the plan is paramount, but record keeping and income requirements also need to be managed.

Your financial adviser will be able to further explain the potential pros and cons of DRPS and help you decide if they are right for you.