Mutual Funds: Growth vs Dividend vs Dividend Reinvestment

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When we invest in a mutual fund, we generally have two options to choose from: Growth Plan and Dividend Plan. There may also be a third option called ‘Dividend Reinvestment Plan’ which is nothing but a type of Dividend Plan. Let us first understand the meanings of these terms.

  1. Growth Option: In this option, nothing is paid to the investors during the investment tenure. All the profits generated by the fund are reinvested in the fund itself.
  2. Dividend Option: In this option, the profits of the funds are distributed to the investors.
  3. Dividend Reinvestment Option: In this option, the profits of the funds are treated as dividends on paper but are reinvested in the fund automatically by the fund itself.

Now the question arises that how an investor should chose the suitable option among these. The short answer to this is that investors under most circumstances should only choose the growth option under the current tax rules. In other words, the dividend and dividend reinvestment options does not make much sense in the current tax scenario whether investing in equity funds or debt funds. Read on to understand this in detail.

Dividend and Dividend Reinvestment options – Making little sense in the current scenario

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There was a time when capital gains used to be taxable and dividends used to be tax-free. Mutual fund houses found a way to pass on the tax benefit of to investors by introducing the dividend and dividend reinvestment options. Under the dividend options, all the gains were paid out as dividends to investors with an option to reinvest the same in the funds. Thus no capital gains arose and the tax-free dividends served as fresh investments. The effect was zero taxation.

Tax on capital gains was later abolished. The dividend options, however, continued as modes to invest in mutual funds. But in effect they did not offer any benefit or disadvantage to the investor when compared to the growth option.

Now, in the current scenario, both long-term capital gains (greater than ₹ 1 lac) as well as dividends are taxed at 10%. Long-term capital gains less than ₹ 1 lac are tax-free. When the mutual funds pays out dividends, it deducts Dividend Distribution Tax (DDT) at the rate of 10% from the dividends distributed and pay out the net amount to the unit holder. So when the gains are less than ₹ 1 lac (which is the case with most investors), the growth option obviously makes more sense. The same is the case when the gains are more than ₹ 1 lac, although the fact may not be as obvious. Capital gains are taxed only when the investment is actually sold by the investor. But the dividends get taxed every time it is paid out to the investor by the fund. This result in a loss to the investor, which can be significant depending on the amounts involved. This may seem to make little sense because the tax rates are same for capital gains and dividends, but one must realize that the dividend tax reduces the amount available for growth at the time of each reinvestment.

Also, the timing and amounts of dividends are not fixed. So you might get dividends at times when you do not really need funds. But you will need to pay tax on those dividends anyways. Does it make any sense? Not to me. So, for all practical purposes, it is best to invest in growth plans under all possible circumstances except when investing for a period less than 1 year. In case of growth plans the gains are classified as Short-term Capital Gains if held for less than 1 year and taxed at 15%. So, for an investment of less than 1 year, the dividend plan does appear to be more useful (although investing in equity funds for less than 1 year is itself a questionable decision anyways).

Also, when you are investing for the purpose of long-term wealth creation the obvious winner is the growth option again. When the funds pay out dividends most of these dividends are not reinvested by the investor and so the total capital invested for wealth creation is reduced by the amount of dividend. On the other hand, under the growth option, the gains get automatically added to the capital which forms a spiral effect and helps the investor to get compounded returns over the term of investment – ensuring accumulation of a big corpus for the investor.

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Now, the dividend options seem to be a good way to generate regular cash inflows. The terminology is such that it confuses the investors and leads them to choose these options when making investments in mutual funds. But in effect, these options lead to losses to the investors due to the tax effect under most circumstances (as seen above). The investors should ideally invest in growth plans and withdraw from the funds whenever they need cash. Also, when the investor is retired and looking for regular income, his/her risk capacity is limited and so investing in debt funds makes more sense for them. In case of debt funds and liquid funds, the dividend distribution tax is charged at the rate of 29.12% (25% tax + 12% surcharge + 4% cess). Under this situation a Systematic Withdrawal Plan (SWP) makes much better sense than a dividend plan because of the huge difference due to tax effect.

We may thus safely conclude that the dividend and dividend reinvestment options have very limited use under the current tax scenario and the clear choice for you as an investor should be growth option.

Also Read: Advantages of Mutual Funds – Why MFs are a Great Investment Option

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