Growth, Dividend or Dividend Reinvestment - What Option to Choose when Investing in Mutual Funds?

In continuation to the Article Part III – Complete Guide on Investing in Indian Markets – Investing In Mutual Funds

When investing in mutual funds, the investor has to choose one amongst three options on where to invest: growth, dividend and dividend reinvestment.

Two most important key factors that determine what appropriate option is for you:

1. Cash requirement and time frame
2. Tax efficiency

Lets get deep into each one by one then we will discuss the factors which should be considered while finalizing the one amongst the three options.

 

Growth Option

In the growth option of a mutual fund scheme, all the profits made by the fund are invested back into the scheme and are not paid to the investor. Hence, the NAV increases over time compounding your principal. Opting for the growth option is similar to the cumulative option in a bank fixed deposit where interest earned is invested back into the fixed deposit account that then sees an exponential growth over a period in time. You do not get any returns till the time you withdraw from your fund either fully or partially.

As per the current laws, the taxation on growth option depends on the holding period: returns from mutual fund units for a period of less than a year attract short-term capital gains and returns from units held for more than a year attract long-term capital gains tax.

 

Dividend Option

In the dividend payout option of a mutual fund scheme, the profits made by the mutual fund are distributed to the unit holders from time to time (quarterly, half-yearly or yearly) but dividends are not guaranteed.

Important Considerations to keep in mind for Investors Opting for Dividend Payout Option while investing in Mutual Funds in India

1. This option is generally opted by the investors to maintain a regular flow of income from their mutual funds investment without redeeming them at all. This payout is however not guaranteed, as if the markets do not perform well; the dividend may be lower than the previous year or nothing at all.

2. Once the dividend is declared, the NAV of your mutual fund will go down by the same value. For example if the fund you invested has a NAV of say Rs. 100 and your fund has declared a dividend of say 10%, that is Rs. 10 then the new NAV will become Rs. 90.

3. The dividends distributed by investing in equity based fund is Tax Free Income in the hands of the investors. However, Dividend arising out of a Debt Fund is subject to DDT (Dividend Distribution Tax), which is borne by the fund house before handing it over to you.

 

Dividend Reinvestment Option

This option works similar to the Dividend Payout option in terms of the reducing NAV and the DDT for Debt Funds, while the Equity Funds enjoy Tax Free dividend.

However the difference here is that the dividend that is declared for the fund, gets re-invested in the same fund at the prevailing NAV. So for instance, you choose a fund ‘X’ with NAV of Rs. 100 from the above example, the NAV after dividend is 90. The 10% dividend you receive will be re-invested on your behalf directly in that same scheme at the NAV of 90 instead of 100, since it reduces after the Dividend is declared.
Thus your invested money is earning for you on its own under this scheme. However, the thing to note here is that the re-invested Dividend is treated as new investment and hence the lock-in periods will start from that re-invested date for those units that are purchased as part of reinvestment. Also you may attract entry load on your re-invested units if the fund has such a provision.

 

Equity Mutual Funds

Dividends from equity mutual funds schemes do not attract any dividend distribution tax (DDT) and long term capital tax gains (for 1 year or more) are also tax-exempt. Short term capital gains (less than one year) on equity mutual funds are also taxed at a flat rate of 15%, irrespective of the investor’s income tax slab.

Investments under equity mutual funds are not intended to be for short term as payment of dividend during your holding term is not guaranteed. Therefore, it makes little sense to invest for short term in the hope of getting a dividend during your holding term. So, if you are expecting markets to perform very well for a span of less than 12 months, then only investment in equities for short term makes sense.

Hence, in case of equity mutual fund schemes it makes no difference whether you opt for the growth or dividend option—as both dividends and long term capital gains from equity funds are tax free. There is little difference between growth and dividend re-investment options in equity funds. The difference will arise only if the units purchased under reinvestment dividend scheme are sold within a year.

 

Debt Mutual Funds

Dividend on debt mutual funds are taxed @ 28.325% (DDT + other charges). Long term capital gains are taxed at a flat rate of 20% with indexation while short term capital gains are taxed as per the investor’s income tax slab.
Hence, an investor’s income tax slab will also play a role in deciding the investment option.

 

Long Term Investment in Debt Mutual Funds (More than 3 years)

Long term capital gains on debt mutual funds are taxed at a flat rate of 20% with indexation which is much lower than tax on dividends (28.325%), therefore it makes sense for the investor to opt for growth option instead of dividend or dividend re-investment option. This is irrespective of the investor’s income tax slab.

 

Short Term Investment in Debt Mutual Funds (3 years or less)

Debt schemes if hold for short term (less than three years), then the capital gains tax will added to income and taxed according to the slab.
If you fall under 10% or 20% tax bracket, then growth option would be better—as interest rate on capital gains (10.3% or 20.6%) will be much lower than on dividend payout (28.325%).
Dividend or dividend distribution option is better if an individual falls under higher income brackets (30% & above) as the DDT of 28.325% is lower than 30% tax bracket.

 

Investments Time Duration Important Considerations Tax Bracket Remarks
10% 20% 3.00%
Long Term Investment in Equity Mutual Funds More than 1 year No DDT & Tax Exempt No DDT & No Tax, Growth is best suited
Short Term Investment in Equity Mutual Funds Less than 1 year No DDT & Tax @ 15% Irrelevant as no guaranteed Dividend
Long Term Investment in Debt Mutual Funds More than 3 years DDT @ 28.325% & Tax @ 20% with indexation Growth Growth Growth 20% tax is less than DTT of 28.325%
Short Term Investment in Debt Mutual Funds Less than 3 years DDT @ 28.325% & Tax as per Tax Slab Growth Growth Dividend / Dividend Reinvestment Growth if income tax slab is less than DTT

So, if you are investing for some long term goal in mind, looking for better returns and do not need any money in between, Growth option is the best one to opt for. While Dividend option can be opted for if you need funds at regular intervals and would want to cash your profits when they are declared. Dividend re-investment can be opted if you like to cash in on your profits then and there, but do not need the money for your own expenses or use, and instead would want to buy more units under the same scheme.

Equity funds are meant for the long term and the objective for most investors to invest in equities are generally to build wealth. That simply means you should stay invested in the funds and not take the cash out to help compounding work for you.
Since long-term capital gains are free of tax; Go for Growth or Dividend Reinvestment options in equity funds. 

In debt funds, choice between growth and dividend re-investment shall be driven by tax considerations.

 

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Growth, Dividend or Dividend Reinvestment – What Option to Choose when Investing in Mutual Funds?

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