Choosing between hundreds of schemes is a difficult task for most mutual fund investors. For newbie investors , another dilemma is whether to go for the growth or the dividend option. While you don't stand to gain or lose significantly with either alternative, there are some aspects that need to be considered to make the correct decision. Let us first examine how one differs from the other.
The alternatives
There are three choices for the mutual fund investor : growth, dividend payout and dividend reinvestment . Under the payout option, profits made by the mutual fund scheme are given to investors at periodic intervals and are not reinvested in the fund. Such dividends are not guaranteed. The amount of dividend paid may also vary. Also, the dividend from a mutual fund is actually cut from the net asset value (NAV). So, the NAV will fall to the extent of dividend paid and the dividend distribution tax (DDT), if any. Suppose, a fund with a face value per unit of 10 is trading at an NAV of 40. It declares dividend of 30%, which means investors will earn 3 per unit. Then, if you choose to sell your holdings, you will get only 37 per unit. Under the growth option, gains made by the scheme are ploughed back into it. This is reflected in the NAV of the scheme, which rises over time. Growth investors earn by selling the scheme at a higher NAV at a later date. Under the reinvestment option, any dividend paid is automatically ploughed back into the same scheme. This means that you buy additional units in the scheme from the dividend amount at the prevailing NAV (ex-dividend ) of the scheme.
Tax implications
While the returns are almost the same for either type of investor, the two differ significantly is in the tax incidence. This also varies according to the choice of fund (equity or debt), holding period (long term or short term) and nature of income (dividend or capital gains). Currently, dividends from both equity and debt funds are taxfree in the hands of the investor. But for debt funds, such dividends incur a DDT of 12.5%. Here’s how taxation affects different categories of investors.
Debt short-term (less than 1 year)
If you redeem your debt fund within a year, the short-term capital gains tax will be added to your income and taxed at the applicable rate. For someone in the 10% slab, growth would be favourable as DDT would be higher at 12.5%. On the other hand, dividend is beneficial for those in the 20% or 30% tax bracket as DDT would be lower than the capital gains tax rate.
Debt long-term (more than 1 year)
If you hold your debt funds for more than a year, the growth option would be more beneficial as long-term capital gains in debt funds are eligible for inflation indexation benefits. With the current high inflation, your long-term capital gains tax liability of 20% on net gains will be lower than the dividend distribution tax of 12.5%.
Equity short-term (less than 1 year)
If you sell your equity fund within a year, you will have to pay a 15% capital gains tax. As dividends from equity funds do not attract any DDT, such investors can opt for the dividend option instead.
Equity long-term (more than 1 year)
Currently, long-term capital gains from equity funds are not taxable. However, if such gains become taxable in the future, this advantage could get eroded. The dividend reinvestment option could then make sense for equity funds. This is because when sold, dividend reinvested represents the cost of the units and is not considered as capital gains, so capital gains incidence is reduced to that extent. Also, dividends reinvested in case of tax plans qualify for tax deduction. The current scheme of taxation for equity funds may undergo a change under the Direct Taxes Code. If implemented, equity fund investors may have to bear 5% tax on dividends.
Other considerations
Investors will have to consider the above tax implications while choosing between dividend and growth. If an investor wants to earn income at various intervals to fund expenses, dividend payout could be the right choice. However, this is not the most efficient way of building longterm wealth as you are losing out on the opportunity to compound your returns over time. This is not advisable unless there is a genuine requirement. Under the dividend reinvestment or growth option, however, you are allowing your money to grow over time. So, if you want to invest for the long term, you should go for either of these options.
The alternatives
There are three choices for the mutual fund investor : growth, dividend payout and dividend reinvestment . Under the payout option, profits made by the mutual fund scheme are given to investors at periodic intervals and are not reinvested in the fund. Such dividends are not guaranteed. The amount of dividend paid may also vary. Also, the dividend from a mutual fund is actually cut from the net asset value (NAV). So, the NAV will fall to the extent of dividend paid and the dividend distribution tax (DDT), if any. Suppose, a fund with a face value per unit of 10 is trading at an NAV of 40. It declares dividend of 30%, which means investors will earn 3 per unit. Then, if you choose to sell your holdings, you will get only 37 per unit. Under the growth option, gains made by the scheme are ploughed back into it. This is reflected in the NAV of the scheme, which rises over time. Growth investors earn by selling the scheme at a higher NAV at a later date. Under the reinvestment option, any dividend paid is automatically ploughed back into the same scheme. This means that you buy additional units in the scheme from the dividend amount at the prevailing NAV (ex-dividend ) of the scheme.
Tax implications
While the returns are almost the same for either type of investor, the two differ significantly is in the tax incidence. This also varies according to the choice of fund (equity or debt), holding period (long term or short term) and nature of income (dividend or capital gains). Currently, dividends from both equity and debt funds are taxfree in the hands of the investor. But for debt funds, such dividends incur a DDT of 12.5%. Here’s how taxation affects different categories of investors.
Debt short-term (less than 1 year)
If you redeem your debt fund within a year, the short-term capital gains tax will be added to your income and taxed at the applicable rate. For someone in the 10% slab, growth would be favourable as DDT would be higher at 12.5%. On the other hand, dividend is beneficial for those in the 20% or 30% tax bracket as DDT would be lower than the capital gains tax rate.
Debt long-term (more than 1 year)
If you hold your debt funds for more than a year, the growth option would be more beneficial as long-term capital gains in debt funds are eligible for inflation indexation benefits. With the current high inflation, your long-term capital gains tax liability of 20% on net gains will be lower than the dividend distribution tax of 12.5%.
Equity short-term (less than 1 year)
If you sell your equity fund within a year, you will have to pay a 15% capital gains tax. As dividends from equity funds do not attract any DDT, such investors can opt for the dividend option instead.
Equity long-term (more than 1 year)
Currently, long-term capital gains from equity funds are not taxable. However, if such gains become taxable in the future, this advantage could get eroded. The dividend reinvestment option could then make sense for equity funds. This is because when sold, dividend reinvested represents the cost of the units and is not considered as capital gains, so capital gains incidence is reduced to that extent. Also, dividends reinvested in case of tax plans qualify for tax deduction. The current scheme of taxation for equity funds may undergo a change under the Direct Taxes Code. If implemented, equity fund investors may have to bear 5% tax on dividends.
Other considerations
Investors will have to consider the above tax implications while choosing between dividend and growth. If an investor wants to earn income at various intervals to fund expenses, dividend payout could be the right choice. However, this is not the most efficient way of building longterm wealth as you are losing out on the opportunity to compound your returns over time. This is not advisable unless there is a genuine requirement. Under the dividend reinvestment or growth option, however, you are allowing your money to grow over time. So, if you want to invest for the long term, you should go for either of these options.
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