While investing in a mutual fund scheme, we often get confused when asked to select among ‘growth’, ‘dividend’ and ‘dividend reinvestment’ option. If you don’t select any of these options, the fund house will select the default option for that scheme as mentioned in the application prospectus. However, you can always change the option later.
Besides the basic returns that you may receive on your mutual fund investment; be it through growth, dividend payout or dividend reinvestment, It is important to consider the tax impact of making your choice. In other words, the ‘post-tax returns’ will differ. This is so because the tax treatment is different for long term and short term holding period. Again, the tax treatment also differs for equity funds and debt funds. Let’s understand some simple rules that you can follow in making the right choice.
Dividend payout option: In case of dividend payout option, the mutual fund scheme will pay you from the profits made by the scheme at regular periods (quarterly, half-yearly or yearly). But, dividends are not guaranteed i.e. you may get the dividend or you may not it.
When a fund house declares dividend, this dividend gets deducted from the NAV (net asset value) of your MF scheme and is paid to you. For instance: If your scheme has an NAV of Rs. 50 and the fund house declared a 10% dividend (Re. 1 on a face value of Rs. 10 per unit), the NAV will decline by Re. 1 to Rs. 49 after paying the dividend. Thus, in dividend payout, the NAV of the scheme falls after the dividend is paid. You receive the dividend in your savings bank account and the NAV goes down to reflect the impact of the dividend paid. If you need regular income, then dividend payout is a good choice.
Dividend reinvestment plan: The term dividend reinvestment plan itself suggests that dividend is not paid to you but is used to buy more units of the scheme by the fund house. Also, in case of dividend reinvestment, the NAV of the scheme declines after the dividend is paid.
Growth option: In growth option, the scheme does not pay any dividend, but continues to grow. Therefore, nothing is received in the bank account and there is nothing to re-invest. Whatever gains are made by selling any fund holdings are invested again into the scheme. This gain can be seen in the NAV (net asset value) of the scheme, which rises over time.
The number of units with the investor also remains the same. Please note in case of growth and dividend payout, number of units remains the same. If your goal is to build wealth to meet your long-term financial goals, then growth option would be the right choice.
Capital gain taxation
Dividend distribution tax: Dividends from mutual funds are tax-free. However, there is a dividend distribution tax (DDT) payable on dividends for debt schemes). The DDT for debt schemes is 13.519%. Besides, the tax treatment of returns from debt schemes investment periods should also be taken into consideration. Here's how different funds are taxed and who should invest in them:
Debt schemes held for short term: If you fall under 10% tax bracket, growth option would be better—as there is no DDT (13.519%). Dividend option is better if an individual falls under higher income brackets (20% or 30% & above) as the DDT is lower. Debt schemes if hold for short term ( less than one year), then capital gains tax will added to income and taxed according to the slab.
Debt funds held for long term: If you want to invest in debt schemes for more than a year, growth option is a better choice. In case of debt schemes, long term capital gains are taxed at 10% without indexation and 20% with indexation.
The current rise in inflation, it is better to hold debt scheme investments for long term and reap the benefits of indexation which is 20% on net capital gains. Thus, an individual’s long-term capital gains tax liability of 20% on net capital gains is lower than the dividend distribution tax of 13.519%.
Equity schemes: It is usually recommended that investments in equity should be for long period (definitely not less than one year) to beat inflation. Dividends from equity schemes do not attract any DDT. If we remain invested in equity for more than one year, then long term capital gains are tax free. If you hold your equity investments for less than 12 months, you will have to pay a 15% tax on the capital gains (if any).
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.