Mutual Funds

Growth or dividend option?

| Updated on July 21, 2012

Investors of mutual funds often face the dilemma of choosing between growth and dividend options. Many leave the decision to the discretion of the financial advisor or the agent. In the process, investors may either miss out on a regular payout opportunity when they need one or end up paying higher taxes from the return obtained.

All mutual funds, be it equity or debt schemes, offer investors to choose between growth, dividend payout and dividend reinvestment options. Let us first know what these options are.

THREE choices

Under the growth option, gains made by the scheme are routed back into the fund. This is reflected in the NAV of the scheme, which rises over time if the fund gains in the market.

Under the dividend payout option, a part of the profits made by the scheme are distributed to investors. The dividend is actually stripped from the NAV of the scheme and accordingly the NAV drops to the extent of dividend and dividend distribution tax paid.

Under the dividend reinvestment option, any dividend paid by the scheme is reinvested back into the same scheme. But instead of getting added to the NAV, units equivalent to the dividend amount are added to existing units. This is similar to investors buying additional units of the scheme with the dividend amount received at the prevailing NAV (ex-dividend).

Purpose of Investment

Before choosing an option, investors should assess their risk appetite. If they prefer to remove some cash from the table when the going is good or actually need some cash flows from the fund then dividend payout is a better option. But this is not an optimal way to build wealth over a long period as the opportunity to compound returns is lost by encashing the profits. In that case growth is a better vehicle.

Tax Implications

Dividend and growth options have different tax implications. Even within growth options the tax treatment varied between asset classes — equities and debt — is based on the period of holding.

Currently, dividends from equity funds are tax-free in the hands of investors, though fund houses deduct a 12.5 per cent dividend distribution tax at source before distributing the dividend for debt schemes. For liquid debt funds, the tax stands at 25 per cent.

Equity Funds

If an investor redeems units of an equity fund within a year from the date of investment, he/she will have to pay a 15 per debt short-term capital gains tax. In such cases taking out profits through dividends may reduce tax burden as dividend on equity funds do not attract the distribution tax.

Investments in equity funds sold after a year, though, will not suffer capital gains tax.

Debt Funds

In case of debt funds, if units are sold within a year from the date of investment, short-term capital gains will be added to one’s income and will be taxed based on the individual’s tax slab.

If an investor belongs to 10 per cent tax slab and wishes to save taxes, going for growth option may be better as the distribution tax is higher at 12.5 per cent. However, for those in higher tax brackets, dividend option is more tax-friendly as the tax would be much lower than their tax-slab rate.

If held for over a year, long-term capital gains on debt funds qualify for inflation indexation benefits. Long-term capital gain tax for debt funds is charged at 10 per cent without indexation or 20 per cent with indexation. This may work more favourably than the dividend payout option from a mere tax point of view.

While tax is a key criterion, your choice should primarily be based on your risk appetite and requirement for cash flows.

(Contributed by ICRA online research desk.)

Published on July 21, 2012

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor