Dividend Reinvestment Plan (DRIP) - Pros, Cons and how to get started

Dividend mutual funds are the funds that aim to provide regular dividends to their investors from the profits generated from the fund. Therefore, such funds are ideal for those who want to receive money from their mutual fund investments without diluting their units.However, there is a sub-variant of dividend mutual funds called the dividend reinvestment plan, also known as the DRIP plan. Such a plan is unique in the way that investors receive additional mutual fund units instead of dividend amounts.

A dividend reinvestment plan is a type of dividend mutual fund where the dividend declared by the mutual fund is not paid out to investors. Instead, the plan automatically purchases more units of that mutual fund with the dividend amount and allocates it to the investors, increasing the number of units held by them.

While both may seem quite similar, they should not be confused to be the same. The basic difference between the two is in the way the NAV of the fund is affected. In a growth plan, the profits generated by the mutual fund are reinvested with the aim to grow its NAV. In a dividend reinvestment plan, the dividend generated reduces the NAV (to the effect of the dividend declared), but you also get more units of the same fund instead of the dividend payout.

• Automated Investments These funds automatically invest the dividend declared to buy more units for the investors. Therefore, the investor doesn’t need to track the information related to the frequency and quantity of dividends announced.
• Accumulation of Units You will be allocated new mutual fund units every time the fund house announces a dividend. The repetition of this process over a long period will result in an increased number of MF units in your fund portfolio.This can help you build a large retirement corpus if the NAV (Net Asset Value) per unit significantly appreciates by the time your exit.
• Cost Averaging A dividend reinvestment plan helps you keep accumulating new units across the highs and lows of the market cycle. As a result, you get more units when the fund’s NAV is low and fewer units when the NAV is high, averaging your total investment cost.
• Compounding Effect As you gain newer fund units that also have the potential to generate returns for you, you can take advantage of the compounding returns over a long period.

• Tax on Dividends One of the biggest disadvantages of a dividend redistribution plan is the taxation on the dividends earned. Even though you are not getting dividends in the form of cash, you still have to pay tax on the dividends earned.While return-wise, a dividend reinvestment plan is quite similar to a growth plan, but the taxation on dividends gives it a huge disadvantage. You are taxed as per your income tax slab. This makes these plans even more disadvantageous for investors in the higher tax brackets.
• NAV Decreases The NAV (Net Asset Value) of the mutual fund decreases whenever dividends are declared, regardless of whether it's a dividend payout or a dividend reinvestment. Therefore, you will need to wait for an extended period until the NAV increases substantially to generate a significant return on your investments.
• No Regular Income Since you don’t get any dividend payouts, you won’t receive any regular income from your investments in dividend reinvestment plans. You will either have to wait until the maturity of your fund or redeem your units to receive cash.
• No Regular Dividend Declarations While DRIPs aim to declare regular dividends, they are under no statutory obligation to do so. The frequency and percentage of dividends are at the fund manager's sole discretion and the fund performance.Besides, the SEBI rule mandates that dividends can only be given from the realised profits of a firm. So, even if the company is doing well on paper, it can’t declare dividends unless it has realised profits.
• Lack of Choices While developed countries like the USA have many mutual funds offering DRIP, not many funds in India offer the choice of automatic dividend reinvestment.

Dividend reinvestment can be a good investment choice for people beginning their investment journey. They provide an opportunity to get additional mutual fund units when the fund makes an extra profit and announce dividend.Besides, you don’t need to invest a lump sum amount in the beginning. You can start with small regular investments through systematic investment plans and step up your investments once you gain more experience and confidence.Moreover, these funds often work best with liquid funds, where dividends are announced daily or weekly.However, you should assess your financial conditions carefully before coming to any conclusion. For instance, a DRIP might not be the best option for a senior citizen as it doesn’t have regular payout options. Moreover, some people might find the growth plans more conducive to their goals and objectives.

• Set Realistic Goals Knowing how much can be a good starting point for investing. Write down your income and all of your current expenses. Now write down the long-term and short-term goals you plan to achieve and see how much you would need to invest.
• Research Once you have set a target for yourself, start researching the various dividend reinvestment options. Don’t limit your search to only equity funds; search for debt funds, FOF mutual funds, etc. as well.
• Consider Manual Reinvesting You can also consider manual reinvesting, where you will receive dividends from your mutual fund and use this amount to manually purchase more units of the same fund.

Whatever investment strategy you choose, consider diversifying your portfolio to mitigate risks. Dividend reinvesting can be a part of your diversification plan in addition to silently working on wealth creation for your financially independent future.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.