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If my correspondence is any indication, investors seem to be more interested than ever before in dividend reinvestment plans, more commonly referred to by the rather unflattering acronym DRIPs.

I’ve been asked questions about whether they are recommended for registered retirement savings plans, how they’re taxed, who offers them, what advantages they confer and more. So, it seems like an opportune time for a quick primer on DRIPs and how they work.

DRIPs give investors the option of receiving their dividends in the form of shares rather than cash. Although most DRIPs are offered by corporations, some exchange-traded funds, mutual funds and trusts (such as real estate investment trusts) also have them.

DRIP shares are issued from the company’s treasury and no commission is charged for the purchase. Not only are the shares commission-free, but some companies offer them at a discount to the market value. Most are in the range of 2 per cent to 5 per cent. Some of the 5 per cent discounters are well known companies such as gold miner Agnico Eagle Mines Ltd. (AEM-T), Crescent Point Energy Corp. (CPG-T), and Pembina Pipeline Corp. (PPL-T). You can find a list of Canadian DRIPs here.

Why do companies offer these plans? DRIP sales bring in new cash. When stocks trade in the market, the company receives no money. The cash passes between the buyers and sellers of the shares. In the case of DRIPs, since investors are receiving shares instead of cash, the money saved can be used for new investments, debt repayment, operating expenses or however else management chooses.

For investors, DRIPs offer the opportunity to make use of two investing principles: long-term compounding and dollar-cost averaging. By adding to your position in a stock each quarter, your portfolio steadily grows over time, assuming the stock you’ve chosen isn’t a dog. And your cost averages out over the years, smoothing the peaks and valleys of market movements.

For example, suppose you buy 100 shares of Bank of Montreal (BMO-T) and enroll in its DRIP program. That allows you to use your dividends to buy more shares of the stock each quarter at a 2-per-cent discount to the market price. The stock currently pays a dividend of $1.33 a quarter so, in effect, you’re receiving a credit of $133 every three months, which is applied to the purchase of new shares. At the current price, that will buy you about one share per quarter. That may not seem like much but, assuming the dividends and the share price maintain roughly the same relationship over time, at the end of five years, you will have added about 20 new shares to your total – a 20-per-cent increase in your position. While that was happening, both the dividend and the share price presumably moved higher.

There’s more. Some (but not all) companies also offer a share purchase plan (SPP). These allow investors to buy additional shares directly from the treasury with no commissions or brokerage fees. BMO is one of the companies with an SPP program. Some others include Bank of Nova Scotia (BNS-T), BCE Inc. (BCE-T), Canadian Imperial Bank of Commerce (CM-T), Emera Inc. (EMA-T), Enbridge Inc. (ENB-T), Fortis Inc. (FTS-T), Imperial Oil Ltd. (IMO-T), Manulife Financial Corp. (MFC-T), National Bank of Canada (NA-T), Suncor Energy Inc. (SU-T) and Telus Corp. (T-T).

Seems like a good deal. Any drawbacks? Yes, a couple.

For starters, taxes. Even though they are received as shares, your dividends will be taxed as if they were cash if the security is in a non-registered account. You’ll get the benefit of the dividend tax credit, but you’ll still have to pay.

The greater concern is keeping track of the cost of all the DRIP shares you purchase over time. That could turn into a nightmare because the cost base will change with every purchase.

The way around both these problems is to confine your DRIP programs to registered accounts – RRSPs, registered retirement income funds, tax-free savings accounts, registered education savings plans and the like. The tax sheltering these plans provide mean you never have to worry about paying taxes on new purchases or calculating cost bases.

DRIPs are an excellent way to build your registered portfolios. Keep them out of non-registered accounts and avoid the headaches.

Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.

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