In your recent column, you recommended that people reinvest their dividends. What is the best way to do this?
Reinvesting dividends is one of the most effective ways to build wealth. It supercharges your returns thanks to the power of compound – or exponential – growth, which is perhaps your greatest ally as an investor.
In the old days, reinvesting dividends was a cumbersome process. You had to enroll your shares in the company’s dividend reinvestment plan (DRIP), which required obtaining the shares certificates from your broker – for which there was a fee – and registering them in your name with the company’s transfer agent. When it came time to sell, you had to deliver the shares to a broker to carry out the transaction.
The benefit of such traditional company-operated DRIPs was – and still is – that they support fractional share purchases. That means every penny of your dividend gets reinvested. Even as electronic record-keeping has replaced paper share certificates at many companies, these DRIPs still operate in much the same way.
Nowadays, investors have more convenient options for reinvesting dividends.
Most discount brokers now offer their own in-house DRIPs. The advantage of these plans is that you don’t have to register the shares in your own name – they stay with your broker – and you have more control over the timing and price when you sell.
The downside is that most broker-operated plans only allow you to purchase whole shares. So, for example, if you receive $50 worth of dividends and the shares you’re reinvesting in trade at $40, you’ll acquire one additional share and the remaining $10 will sit in cash. That means you won’t get the full benefit of compounding.
The good news is that there are some easy workarounds.
Searching for the sweet spot of yield and dividend growth
One solution is to sweep the residual cash into a low-cost index mutual fund periodically. Mutual funds don’t charge commissions on purchases, so it’s a cost-effective method for putting all your money to work. What’s more, mutual funds allow partial unit purchases, and they generally reinvest their dividends by default, so they make the most of compounding. The disadvantage of this method is that mutual funds typically charge relatively high management expense ratios (MERs).
But there’s a way around that, too. A few years ago, with the arrival of commission-free exchange-traded funds at many brokers, I stopped using mutual funds to soak up the cash in my account and turned to ultralow-cost ETFs instead. For example, one of the ETFs I use is the BMO S&P/TSX Capped Composite Index ETF, which has an MER of just 0.06 per cent. There are many low-cost ETFs out there; I suggest you check to see if your broker supports commission-free ETF trades and, if so, which ETFs qualify.
I still occasionally buy shares of individual companies – and pay a commission – if I have a chunk of cash to invest in a stock that looks especially attractive. But the simplicity and cost effectiveness of sweeping cash into a low-cost ETF is appealing. It makes the most of compounding, with the added benefit of enhancing diversification.
My broker includes reinvested dividends in calculating the adjusted cost base (ACB) of stocks in my non-registered account. Since these dividends are declared each year as investment income and I pay tax on them, the ACB that my broker shows on my statement is not accurate. Do all brokers do this?
I don’t see a problem here. Adding the value of the reinvested dividends to your adjusted cost base is exactly what your broker should be doing. If your broker didn’t increase your ACB each time you purchase shares in a dividend reinvestment plan, you would end up paying more tax down the road, not less
Consider this: If you were to invest, say, $1,000 of your own cash to buy additional shares of a company, you would increase your ACB by $1,000 to reflect the cost of the new shares. Well, reinvesting $1,000 of dividends is essentially the same. It’s your money, and you’re using it to buy additional shares. The only difference with a DRIP is that the purchase happens automatically, without the cash landing in your brokerage account first.
True, you must pay tax on dividend income received in a non-registered account, even if the money is reinvested. But by increasing your ACB, you will reduce your future capital gain for tax purposes – or increase your capital loss – when you eventually sell the shares. So, increasing the ACB is a benefit for you, because it prevents you from getting taxed twice.
I can’t say that all brokers add the value of reinvested dividends to the ACB, but they certainly should. That’s why it’s important to check your broker’s figures to make sure they are correct.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
John Heinzl