Cut the cost of reinvesting dividends

Reinvesting dividends is an important part of growing your portfolio over the long-term. But doing so cheaply enough may be difficult. Unless your portfolio is large or you are adding new money frequently, it can take some time for your dividends to build up to the point where they can be reinvested cost-effectively.

However, there are a handful of ways in which smaller investors can reinvest dividends promptly without incurring excessive costs. These include using scrip dividend schemes, opting into company dividend reinvestment plans and using cheap reinvesting, or regular investing, schemes offered by brokers.

Paper dividends

A scrip dividend is a dividend that's paid in shares that have been newly issued by the company, rather than in cash. By itself, this isn't worth much. If a company has 100 million shares in issue and gives each shareholder another share for each one they hold, there are now 200 million shares in issue. Each is worth half as much as before, no cash has changed hands and nobody is any better off.

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Hence scrip issues are popular with companies that may be cash-strapped and want to appear to be paying a dividend without handing over any money. However, if companies offer a scrip option for the dividend at the same time as continuing to buy backtheir shares, the dilution caused by the scrip issue is offset by the buybacks.

In this situation, as an individual investor you are effectively getting your dividend in existing shares, not newly created ones.Scrip dividends used to be fairly common among major UK firms, but have fallen out of favour due to corporate tax changes. However, a few blue chips still offer them.

If you hold your shares in these in certificated form, or in another form where your name is on the register of shareholders such as a personal Crest account you can opt to receive scrip dividends. If you hold your stocks in a nominee account at a broker which most people do your name isn't on the register of shareholders, so you can't opt for the scrip dividend personally. Whether you can still get scrip dividends depends on whether your broker offers you the choice.

One fairly cheap option that does is HSBC InvestDirect, which has no account fees or inactivity fees (although an HSBC current account isneeded to use the service).

Dividend reinvestment plans

Many major companies that don't offer scrip dividends provide a dividend reinvestment plan (Drip) instead. A Drip looks similar to a scrip scheme, in that the company gives you shares in the place of cash dividends. But unlike scrip dividends, the shares you get from Drips are purchased in the open market using the dividend.

The shares purchased for a Drip are subject to stamp duty and commission, so a Drip has higher transaction costs than a scrip dividend. To opt into a Drip, you'll need to hold shares in certificated form, in a personal Crest account, or sometimes in a corporate sponsored nominee (a corporate sponsored nominee is essentially a nominee account run by the company's registrar and often used for holding shares given to employees).

Few brokers offer certificated dealing and personal Crest accounts any more, so this maynot be an ideal or cheap option. However, some brokers offer their own dividend reinvestment services, which are entirely separate to the company-run Drips, but often priced in a similar way.

These allow you to reinvest dividends at a reduced commission. You could also consider flexible regular investing schemes that allow you to invest a fixed amount in a given stock, or stocks, every month. Again, these charge a lower-than-usual commission. A number of brokers provide one of these options: iWeb and Youinvest offer good-value services.

How reinvested dividends are taxed

The fact that you're reinvesting the dividend makes little difference to the tax treatment with UK stocks. The dividend will be subject to income tax at your usual dividend tax rate (effectively, no tax for basic-rate taxpayers, 25% for those on higher rate and 30.56% for those on top rate). Scrip dividends are broadly similar, with tax based on the value of the cash dividend given up for the scrip.

But if the market value of the scrip shares on the first day they begin trading is more than 15% higher than the cash foregone, tax will be based on the market value instead. Capital gains from shares obtained with the dividend will be subject to the usual capital gains tax rules.

Scrip schemes offered by foreign stocks may have different tax treatment. For example, Santander's dividends are taxed at 20% by the Spanish government. You can reclaim 10% of that from Spain if you think it's worth the hassle. You are also potentially subject to UK capital gains tax on the cash dividend (not income tax, for reasons of Spanish corporate law).

But Santander's scrip dividend is not subject to Spanish withholding tax, nor to UK tax (since it's treated as a bonus issue). That makes it simpler and more tax efficient to take the scrip dividend option if you can.