The article “What are the pros and cons of using a DRIP account for your investments?” was originally published in Financial Post on January 20, 2023. PHOTO BY MICHAEL NAGLE/BLOOMBERG FILES.
Using DRIPs in a taxable account could have unintended long-term consequences
Q: “What are the pros and cons of using a DRIP (dividend reinvestment plan) account in an unregistered account? What tax consequences should I look out for?” — Peter, Timmins, Ont.
FP Answers: A DRIP is offered by all major investment brokerages in Canada. Though the term specifically refers to dividends, these plans usually apply to any source of income that an eligible security produces. The concept is simple in that when you purchase dividend- or income-paying securities, they are often eligible for dividend reinvestment, which allows the investor to automatically purchase additional full and/or fractional shares of the security at no additional cost.
The benefits of a DRIP are many, the most obvious being the ability to buy additional shares of a company you own without any extra commission fees. This feature was especially useful in years past when commissions at brokerages were much higher than they are today. Depending on the size of your account and current brokerage, this could save hundreds of dollars a year in commission fees.
For small accounts in particular, the cost of investing significantly drops for stock investors (direct ownership) and even for exchange-traded-fund (ETF) investors. With smaller balances, the cost to trade small amounts could be significant on a percentage basis.
For example, if you had an account with $5,000 and received annual cash dividends worth three per cent (or $150) from a DRIP program, these get reinvested with no additional commission fees. If you did not have a DRIP, a $10 commission to deploy this cash into a position ends up costing you about 0.5 per cent of the value of your portfolio, but a whopping 6.67 per cent of the amount being reinvested.
Using DRIPs can save on the overall cost of investing, but it can also increase your cost if you interpret this benefit with a singular focus. For example, if you choose a DRIP and have a tax-free savings account (TFSA) or registered retirement savings plan (RRSP) contribution room, you may be missing out on the tax benefits of these registered plans.
If you fund your TFSA or RRSP by annually withdrawing funds from a non-registered account, it could make more sense to not use a DRIP for your non-registered holdings and use the cash available from these distributions to fund registered plans. In doing so, you could avoid triggering an undesirable capital gain or loss when selling these holdings. Alternatively, you may want to trigger gains or losses each year due to either high or low income in that particular year.
Taking the previous point one step further, some brokerages allow for full flexibility to turn a DRIP “on or off” with a simple phone call or by logging into your account online. This could be useful in years when you may want to take the dividend in cash rather than buying more shares.
You might also want to keep in mind that certain brokerages do not allow you to “undo” a DRIP, meaning that if you indicate you would like a DRIP when buying shares and then change your mind, you may not be able to remove the DRIP.
This can become extremely inconvenient, because you would be forced to sell shares or units and repurchase them, potentially triggering gains/losses in the transaction to simply alter your DRIP preference. It helps to ask your broker questions before looking at potential strategies such as this one.
Dividends that are usually available through a traditional DRIP program are considered taxable income in the tax year received since they are essentially cash dividends. Your adjusted cost base increases when these dividends are reinvested since you are purchasing additional shares with this cash.
The same logic applies to managed products such as ETFs. With ETFs, you are buying more units of the fund rather than buying more shares with a DRIP. This is an incredibly efficient way to dollar-cost average.
In simple terms, the tax treatment of receiving a dividend or other portfolio income is the same whether you are enrolled for a DRIP or not. It would be prudent to understand what exactly is being “dripped” in your non-registered account.
There is a significant tax advantage to receiving eligible dividends from Canadian corporations in a taxable account (rather than other income such as interest or foreign dividends) since these receive preferential tax treatment.
In reviewing your asset allocation across all accounts, you may want to consider holding your dividend-paying Canadian equities in a non-registered account. This makes a DRIP that much more efficient because you are increasing your allocation of tax-preferred, dividend-paying stocks via regular DRIPs.
Using DRIPs in a taxable account could have unintended long-term consequences from a tax and diversification standpoint, because it can steer your portfolio away from its target asset allocation and result in higher capital gains tax.
From a diversification standpoint, especially if you are holding individual stocks, you may end up DRIPing all these holdings while your cash and fixed-income positions are left untouched. Over several years or decades, this could result in a misallocation of capital vis-à-vis your risk tolerance.
By leaving the DRIP in place, you are essentially allowing your portfolio to appreciate on auto-drive. The DRIP’s features make managing a portfolio virtually effortless, which may lead to complacency and ignorance, and a slow creep in asset allocation towards dividend-paying equities.
On the other hand, if you are not using a DRIP, you may be more likely to allocate unused cash to other securities, thereby rebalancing your portfolio at time intervals that match up with your income distributions.
Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at firstname.lastname@example.org.