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What Are Dividend Reinvestment Plans?

NEW YORK (TheStreet) -- Jim Cramer loves companies that make dividend distributions -- because as a shareholder, a.k.a. owner in the company, he believes you deserve your piece of the profits. Which is exactly what dividends are.

And now is the season for quarterly dividend announcements. Dividends are in the air.

But what should you do with those quarterly dividend checks? Cash them and go shopping? As fun as that sounds, it's not doing much for your portfolio. Have you considered a dividend reinvestment plan, a.k.a. a DRIP? Many of you have asked questions about these, so apparently DRIPs are on your mind.

Basically, if you plan on holding a stock for a while, you probably should be a part of the company's dividend reinvestment program. But even if you're an active trader, a DRIP can still be a great way to add shares to your position without extra fees.

So let's dissect the DRIP.

What's a DRIP?

It would be so easy to make an ex-husband joke here -- but I'll restrain myself. Simply put, a dividend reinvestment plan is a way for shareholders to reinvest their dividends back into the company. Instead of getting those dividend checks sent home, the company keeps the money and buys more shares for you.

Take note: Even though you're no longer getting those checks in the mail, those reinvested distributions are still taxable income to you. You can't escape Uncle Sam.

Reinvesting your dividends can make a huge difference in the amount of shares you hold over the long haul. "You could end up with as many as two or three times as many shares as you started with," says Bob O'Hara, vice president of development at BetterInvesting, a nonprofit long-term investing advocacy group.

Here's the bigger upside: Since you're buying the shares directly from the company, there are no broker fees for the purchase. Yippee! And you usually only need to own one share of a company's stock to be a part of its DRIP. That's why everyone should start giving little kids shares of stock for special occasions.

My stepbrother gave my daughter a few shares of Coca-Cola when she was a baby. I reinvest the dividends for her and, although she's only 2 1/2, she's got quite a little portfolio. Brilliant.

But my precious little girl is not the only one benefiting from these DRIP plans. Clearly, there must be perks to the companies that offer these plans as well. Of course, to start, they have immediate access to your money. When you buy a share on the open market, you're essentially buying it from another seller. With a DRIP, you purchase right from the company so your money is immediately in their hands.

In addition, companies like a solid shareholder base. If you're a DRIP investor, you're pretty committed to the stock. If the market goes down or a negative one-time event happens, you wouldn't be as quick to jump ship as someone who didn't have as much of a vested interest in the place.

Take AFLAC's DRIP. With 64% of its shareholders participating, the company's got a ton of loyal shareholders that probably aren't leaving any time soon. "The plan is one of the best around," says O'Hara.

How do you find a DRIP?

There are about 1,600 companies offering DRIPs these days, so first figure out if your company is one of them. Go to the investor relations section of its Web site or check out stock sites like StockSelector.com that list companies with DRIPs.

DRIPs can vary from company to company. Some companies only let you buy new shares based on the amount of dividends you're reinvesting. Others allow you to add some cash and buy more shares. Do some legwork and make sure you understand the plan.

If your company has a DRIP and you want in, you have a few choices. First, you could buy directly through the company. Fill out the paperwork and -- voila! -- you're a DRIP member.

But tracking all those purchases can get onerous. Every time your dividends are reinvested, you'll have a new lot of shares. You'll need to keep a spreadsheet of every purchase, including the share price you paid and the date of purchase, so you know your cost basis when you decide to sell those shares someday.

A better option might be to set up your DRIP through your brokerage, without going directly through the company. "Most Internet-based brokers allow you to reinvest your dividends for no charge," says O'Hara. For instance, sites like ShareBuilder and MyStockFund will let you reinvest for free. Then you'll have all your trades under one roof.

One caveat: You may need the stock certificates issued in your name to qualify for the DRIP through your broker, so be sure to check into that.

The DRIP Downers

While DRIPs allow you to add to your position without incurring heavy fees, there is some downside:

  • Most DRIPs decide what day your new shares will be purchased -- usually once a month. So if you're a short-term trader, trying to buy in the dips, this might not work for you. Fortunately for the long-term investor, this isn't an issue.
  • You can only sell on certain days. If you're trying to get out of a stock because of bad news, it might not be so easy. Again, not a problem for the long-term guy.
  • Watch the fees. There may be extraneous fees just for being involved in the DRIP. Stay away from those plans. Try to invest only in DRIPs that don't charge you anything extra.
  • Hone your record keeping. If you're in for the long haul, you could have hundreds of dividend purchases. Create a spreadsheet that tracks all those trades or use a program that tracks your trades for you, like GainsKeeper. Otherwise, see if you can participate in the DRIP through your broker.

But even with all that, a DRIP could still be a cheap way to amp up your position. So get to know the DRIP.

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