Why You Should Avoid DRIPs in Taxable Accounts

Last week’s post about calculating your adjusted cost base with ETFs drew some interesting comments. It’s clear that many DIY investors who use non-registered accounts were unaware of how much work is involved in accurately reporting capital gains.

Careful record-keeping is an unavoidable burden for taxable investors, but you don’t need to make it any more difficult that necessary. Yet as one reader pointed out (hat tip to Jas), some investors complicate their lives by using dividend reinvestment plans in non-registered accounts.

DRIPs allow you to receive ETF distributions—whether stock dividends, bond interest, or return of capital—in the form of new shares rather than cash. You can only receive whole shares, so if the ETF is trading at $20 and you’re eligible for $87 in distributions, you’ll receive four new shares plus $7 in cash. These plans are extremely popular with do-it-yourself investors, and they can be beneficial, since you pay no trading commissions on the new shares and your money starts compounding immediately rather than sitting idly in your account.

But although they are convenient in RRSPs and TFSAs, dividend reinvestment plans are usually not a good idea in taxable accounts. That’s because reinvested dividends must be added to the cost base of your ETFs, as Justin Bender and I explain in our white paper, As Easy As ACB (see page 9, Step 4).

Well, technically, you don’t have to increase your adjusted cost base to account for reinvested dividends. But if you don’t, you’ll pay more tax than necessary when you eventually sell the ETF shares. If you’re a long-term investor, that additional tax bill can be enormous.

The additional record-keeping caused by DRIPs was cumbersome enough when funds paid distributions quarterly or annually. But these days many ETFs make monthly payouts, which means you’ll be making 12 entries a year for every ETF that has a dividend reinvestment plan. That’s a lot of paperwork for a dubious benefit. It typically makes more sense to take your distributions in cash and add use them to purchase new shares whenever you add new money or rebalance your portfolio.

A final note: Some readers asked exactly how capital gains and losses should be reported to the Canada Revenue Agency. The CRA has produced a document called Tax Treatment of Mutual Funds for Individuals that should answer those questions. Remember to always consult an accountant or other qualified tax expert if you need specific advice.

43 Responses to Why You Should Avoid DRIPs in Taxable Accounts

  1. Michael James April 8, 2013 at 8:12 am #

    Good point. Over the years I’ve maintained a separate spreadsheet tab to track ACB and proceeds of disposition for every stock and ETF I’ve owned in a taxable account. Fortunately, even in my most active years I only had between 10 and 20 entries. Having to add monthly entries for all of them would have been very tedious.

  2. SterilngF April 8, 2013 at 12:15 pm #

    So even though I will be calculating ACB properly myself my fund company will still provide me with the transaction information that I need to do this (ex. statements & confirmations)??

  3. Andrew F April 8, 2013 at 1:26 pm #

    This is one reason why I prefer quarterly distributions to monthly.

  4. Canadian Couch Potato April 8, 2013 at 2:40 pm #

    @SterlingF: Not sure I understand your question. Your brokerage should provide you with the necessary information about reinvestment dividends, but you will still have to do the paperwork to see how these impact your adjusted cost base.

  5. SterilngF April 8, 2013 at 3:13 pm #

    @CCP: That was my question. My brokerage will be able to provide me with the information but then I need to go and key it all into AdjustedCostBase.ca for example.

  6. Bill B April 8, 2013 at 5:07 pm #

    I buy ETFs in a TD Waterhouse accounts using a DRIP. My monthly statements have columns for Book Value and Market Value and shows separately each month the amount charged for the new units purchased under the DRIP. I thought that the Book Value amounts would have included the amount charged for the units bought under the DRIP. Based upon your articles it seems that is not the case Please advise if the Book Value amounts on the montly statements don’t include the amounts paid for the DRIP units acquired.

  7. geekay April 8, 2013 at 5:10 pm #

    I’ve had accounts with both NBF and Investorline. Both these brokerages provide “average cost” figures on the statements, which are the current ACB values (they disclaim their accuracy for legal reasons only). I did once do a tedious ACB calculation myself for some holdings that spanned about 15 years, and it did match the broker-provided calculation. Note that this will be accurate only if the whole history of the shares is with the same brokerage; you’ll have to do some calculation yourself if shares were transferred in, because they wouldn’t have the purchase history.

    Being with one broker now, I just take it on faith that their computed average costs
    are correct when I declare capital gains.

  8. Canadian Couch Potato April 8, 2013 at 5:11 pm #

    @Bill B: Unfortunately, the book values provided brokerages do not typically include accurate adjustments for DRIPs. If there’s one takeaway message from my last two posts, it’s this: don’t rely on your brokerage to accurately calculate your ACB.

  9. Paul G April 8, 2013 at 5:55 pm #

    To me, this is one of the reasons to start with ETFs rather than index mutual funds: one of the things you can learn along the way is what’s complicated, and what isn’t. Even better, you learn and make your mistakes with the amounts in question are still small enough not to matter too much.

    ACB, to me, counts as complicated, and now going through the process of calculating this when doing my taxes might actually lead me to sell off certain assets and manage things differently.

  10. Kevin April 8, 2013 at 8:46 pm #

    If I’m not mistaken, this would be another reason to use HXT for your Canadian equity in a taxable account- ACB is just the addition of your contributions.

  11. My Own Advisor April 8, 2013 at 9:14 pm #

    Dan,

    Like Bill B, I always thought the book value amounts at discount brokerages were adjusted for reinvested dividends. I recall most brokerages do this for you.

    The challenge comes when/if you’ve invested in one or more discount brokerages and/or you’ve used a stock transfer agent for full DRIPs. The ACB is on you before you transfer stocks into the brokerage.

    DIY, geez, always something to be on top of :)
    Mark

  12. Canadian Couch Potato April 8, 2013 at 9:28 pm #

    @Mark: I don’t mean to make categorical statements that apply to all brokerages, but I know Justin has a lot of experience in this area and he has personally found many incidences of brokerages doing this inaccurately.

  13. Joe April 8, 2013 at 10:17 pm #

    I am not sure why DRiP’s are so tedious. For an ETF which pays dividends of which consist eligible dividends and ROC, the DRiP only adds two entries per month. One entry for the ROC which you can use a dummy value until you receive your T3 slip and the reinvested dividend. The ROC lowers your ACB and the reinvested dividends raise it. Why is this so tedious? It takes me a couple of minutes to copy the previous month and update a few fields. Then a few more minutes in April. So the savings is 12 entries instead of one? For the small amount of time I would rather save the trading fee.

    Unless I am missing something here.

  14. Holger April 9, 2013 at 12:08 am #

    I’m with Joe on this one. With an ACB tracking sheet set up along the lines outlined in the aforementioned paper, the monthly effort is maybe a minute or so.

    Apart from the bookkeeping effort, DRIPs still have their value if you want to stay fully invested or want to minimise costs.

  15. Holger April 9, 2013 at 12:14 am #

    PS: Book values as displayed by discount brokerages are indeed not very useful. For example, in my RBC DI account they get the DRIP right, but not the ROC.

  16. Nathan April 9, 2013 at 1:55 am #

    @Joe: I think the idea is that you’re making regular contributions anyway, so you don’t really save any transaction fees. If you don’t use DRIPs, you can simply take the cash from the dividends and lump it in with your next (say, monthly) contribution. The only down-side is that the money is not invested between the dividend date and your next contribution date. As far as the amount of work, to each his own. If it’s not a hardship for you, give’r. For many couch potatoes though, one of the key benefits of this approach is minimal effort. 12 times the record keeping isn’t minimal. :)

  17. Canadian Couch Potato April 9, 2013 at 8:10 am #

    Thanks for all the comments. My suggestion to avoid DRIPs in taxable accounts is not a hard and fast rule. For those who are comfortable with the additional paperwork, they’re fine. But it’s clear from the comments that some investors are not bothering with the paperwork and just assuming their brokerage is doing it for them. And others have confirmed they would just as soon take the distributions in cash and use them to rebalance.

    Remember that not everyone has the same interest or abilities when it comes to managing their portfolio.

  18. lucas April 9, 2013 at 9:42 am #

    Intereting articles as always. It does bring into the question of investing in a taxable account, ie i would like to know peoples thoughts on a specific investment portfolio within canadian small businesses would be, in the context of tax advantaged claymore, ishares coming out of favor in the couch potato website.
    hxt?
    any use on vti, vxus?
    is CAB out of favor?

  19. Justin Bender April 9, 2013 at 10:02 am #

    @My Own Advisor, @Bill B

    Just to clarify, I find many brokerages are not processing “reinvested capital gains distributions” accurately. These are also referred to as “notional shares” or “phantom shares”. You do not receive any new shares but the cost base increases.

    If you have a “DRIP” set-up, I would hope the brokerage is accurately tracking these buys…although by reading some of the comments above, this may be a stretch.

    Return of capital adjustments and USD currency adjustments are also extremely suspect, from my experience.

  20. ZB April 9, 2013 at 1:49 pm #

    My BMO IL T3 for ETFs with DRIP had capital gains already calculated. For me, is it as simple as that, or do I need to calculate manually?

  21. SterilngF April 9, 2013 at 3:00 pm #

    @CCP and @JustinBender:
    Thank you, thank you, thank you!

    Last night I keyed in all my transactions into AdjustedCostBase.ca using your “As Easy As ACB” paper. There is NO WAY I would have figured that all out myself. From Jan 2012 till now I had to key 43 transactions!!! It would have been more but “luckily” the dividends for two of my funds weren’t enough to buy even a single share. I called today and discontinued my DRIP on that account. :D

    I have a question for clarification. The transaction you have in the paper that is a distribution on 3210 SHS (it is the 3rd one)…am I right in assuming that these are covered off in “Step 6″ using the “Total Non Cash Distribution ($) Per Unit” amount? So I only have to key in one for the year instead of each one of these?

  22. Justin Bender April 9, 2013 at 4:43 pm #

    @SterilngF:
    I’m glad you found the paper useful. In response to your question, are you referring to the reinvested “dividend” (DRIP) on 3,210 shares (where we purchased 12 additional shares, increasing the cost base), or the reinvested “distribution” on 3,222 shares (where no new shares were purchased, but the cost base was increased)?

  23. SterilngF April 9, 2013 at 5:25 pm #

    @Justin: I believe the 2nd one you referenced (but it should be 3,210 shares not 3,222 in your comment). The distribution credit of $198.67 @ $0.062 for 3210 shares. It doesn’t have a red circle so it’s not one of the ones that we create an entry for. It seems like something you should create an entry for so I was curious if it was part of the “Total Non Cash Distribution ($) Per Unit” entry.

  24. Justin Bender April 9, 2013 at 5:39 pm #

    @SterilngF – ahhh, now I gotcha. That is simply a dividend being distributed to the account. If you did not have a DRIP set-up, this amount would just go to cash. It would not be included in the calculation of your cost base.

    In your specific case, since you never had enough cash from the dividend to purchase an additional share, these amounts would not be added to the cost base. They simply are directed to the cash balance of your account.

    You may not have as many transactions to enter as you thought :)

  25. My Own Advisor April 9, 2013 at 9:23 pm #

    @Justin,

    Good to know, and to be wary of.

    I called my discount broker after this post, they assured me they calculate ACB for me. I only DRIP stocks unregistered so that simplifies things for me a bit. No ETFs or REITs unregistered. That said, back to brokerage, what else are they going to say? ;)

  26. SterilngF April 9, 2013 at 11:21 pm #

    @JustinB: Sadly, I didn’t include these transaction in my 43 so that number is right. That’s made up of only the ones labelled “DIV REIN” and “BUY” (I didn’t have any sales) and all the ROC ones as well.

    I feel dumb for saying but I just realized something…if I’m not reinvesting the dividends in my taxable account I can take the cash and invest it in my TFSA each year. Why have I never thought of that before? LOL

  27. New Investor April 14, 2013 at 12:12 am #

    Sorry for going off topic but I was wondering whether it is more tax efficient to hold VTI or VXUS in a non-registered, taxable account?

    My RRSP and TFSA are currently maxed out and I hold ZCN in my taxable account. In order to achieve my desired asset allocation I have will have to add either VTI or VXUS to my taxable account.

    After researching articles on this website I am leaning towards VXUS as I believe the foreign withholding tax is non-recoverable in both registered and non-registered accounts. However, I will be able to recover any US withholding tax. Therefore, from a pure tax efficiency standpoint it seems that holding VXUS in a non-registered account is comparable to holding it in a TFSA/RRSP.

    I just want to make sure I am correct in this assessment before pulling the pin on a trade.

    Thank you.

  28. Canadian Couch Potato April 14, 2013 at 8:02 am #

    @New Investor: The first point is that I hope you’re not going to avoid either VTI or VXUS based on foreign withholding tax. Investors should hold both: the only decision should be the most tax-efficient location for each fund.

    As you’ve anticipated, the international withholding tax will be lost no matter where you hold VXUS. The 15% US withholding tax applies to both funds, but VTI has a lower dividend yield than VXUS (2% versus 3%). Since foreign dividends are taxed like interest, you would want the ETF with the lowest yield in the non-registered account, so that would be VTI.

  29. New Investor April 14, 2013 at 1:22 pm #

    Hi CPP,

    Thank you for the information.

    I do hold both VTI and VXUS equally in my RRSP which is currently maxed out. I just wasn’t sure which fund would be the best to hold in a taxable, non-registered account.

    I am now going to allocate my future RRSP room to VXUS and begin purchasing VTI in my taxable account.

    Thanks again!

  30. alex April 15, 2013 at 11:52 am #

    I’ve always wondered, what does it matter if your ACB is exact or not? I mean nobody know the exact amount until you calculate it urself. How is CRA going to know it was 19,32$ instead of 19, 38$ ???? And if they know I’d rather they waste time calculate it than me. As some famous dripper said : I don’t do the ACB cause I will keep it until I die.

  31. qas April 21, 2013 at 6:26 pm #

    With an appropriate spreadsheet a monthly drip does not require much work.

    Interestingly in this discussion (and similar ones on different forums e.g. FWF) there is no mention of the cost benefit other than transaction fees. I have numerous dividend stocks in taxable accounts and *one* of the considerations on which to drip is the 3%-5% discount that some provide

  32. Steven J Fromm April 27, 2013 at 11:56 am #

    We have the same tax issue in America with DRIPS but it seems that a lot of the investment houses and companies offering such arrangements are good at tracking basis. For some older investors with old DRIPS this can be an accounting nightmare.

  33. Srini Murthy May 28, 2013 at 9:40 pm #

    Are dividend ETF’s better option than buying individual stocks from tax perspective?
    Are DRIPS recommended only for TFSA and RRSP?
    Your help is appreciated

  34. Canadian Couch Potato May 28, 2013 at 10:18 pm #

    @Srini: The tax treatment of Canadian dividends is the same whether you hold the stocks directly or in an ETF or mutual fund. With US stocks, it is more tax-efficient to hold the stocks directly than to hold them via a Canadian-listed ETF or mutual fund because you can avoid (or to reclaim) the foreign withholding taxes by doing so. (Holding them in a US-listed ETF also offers this advantage.)

    Yes, I would tend to recommend DRIPs only for TFSAs and RRSPs, where you do not need to calculate the adjusted cost base.

  35. Srini Murthy May 29, 2013 at 8:54 am #

    Many Thanks for your quick response. It is a pleasure to go through your site that is both informative and educative.

    Thanks

    Srini

  36. Carole Mehner July 16, 2013 at 3:18 pm #

    Hello fellow DIYers, I’ve used Quicken for about 20 years to track my investments, when my broker decided that my account was too small The Return of Capital is just fill in the boxes. My numbers are sometimes +/- a few cents of BMO Investorline. No problem for me. And the learning curve is not too steep, once you get set up. I update my version about every 10 years (about $100, if you wait for sales)

    Because I’ve changed brokers twice, my current cost per share is incorrect. Investorline will adjust it to what numbers you give them over the phone. I have those numbers in Quicken, even for stock I’ve had for 30 years.
    P.S. Dividends are + $500 from a year ago. I really like looking at those numbers!

  37. Mark August 9, 2013 at 9:18 pm #

    I have a question about DRIPs. I am a non-resident Canadian and through my brokerage, I have the option whether to collect cash or securities from bond dividends. I have been selecting securities and it goes through even though I am a non resident. It says the DRIP plans are only open to residents of Canada. Am I breaking a tax law somewhere? Would you recommend this or just to select cash? Thx

  38. Canadian Couch Potato August 10, 2013 at 12:13 am #

    @Mark: I suggest you speak with a tax specialist. I’m not qualified to answer your question.

  39. Jas May 28, 2014 at 1:40 am #

    @CCP:
    One advantage of TD e series mutual funds over index ETFs is that the distributions are made only once a year…I find that using the “DRIP” option with automatic reinvestment of distributions once a year isn’t too cumbersome to keep track of the ACB.

  40. Canadian Couch Potato May 28, 2014 at 4:09 pm #

    @Jas: Actually mutual fund companies tend to do a very good job of tracking ACB for you. It’s really only ETFs at discount brokerages that can potentially be a hassle.

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