Which option among Growth vs. Dividend Option you need to choose in Mutual Funds to earn higher returns and tax efficiency
In mutual fund selection Growth vs. Dividend Option usually take the center stage after you have decided on other factors. Each option brings its share of advantages and disadvantages. Deciding which one to choose depends on your financial goals, tax planning preferences and mode of investment opted.
First, let us get into the details of Growth Option and Dividend Option:
In the growth option of a mutual fund scheme, you move out of the option to receive dividends. It means all the profits earned by the fund are invested back into the scheme. Hence, it results in a gradual increase in the NAV of the fund due to the power of compounding over time. It can be perceived analogous to the cumulative option of a bank fixed deposit. In such an option, the interest earned on the FD is put back into the fixed deposit account. Ultimately, the fixed deposit earns interest on interest, and the corpus swells over time.
Also read: Power of Compounding
It broadly consist of two options
Dividend payout option
In dividend payout option of a mutual fund scheme, you issue a mandate to the fund to pay you dividends in cash. In other words, the profits earned by the fund would be distributed to the unit holders from time to time. It ultimately leads to a fall in your NAV. It’s because the fund pays you dividends by redeeming some of your units.
The impact of Dividend payout option on NAV of the fund is illustrated as below:
One thing needs to be underscored here. After payment of dividends in cash, your holdings would be valued at Ex-dividend NAV. It means that if the earlier value of your holdings was Rs 20000 (1000*Rs 20). Then upon exercising dividend payout option, the value of your holdings would be reduced to Rs 15000 (1000*Rs 15). It implies that you would keep holding the same number of units, but the value of each unit would decline.
Dividend Reinvestment Option
In Dividend Reinvestment Option, dividends declared by the fund are not paid out to you in cash. Instead, the fund purchases additional units on your behalf out of the dividend amount and transfers them to your individual account. It may look similar to growth option but impacts your wealth accumulation in a different manner.
In growth option, the capital appreciation occurs due to a steady rise in the NAV. But in the case of dividend reinvestment option, capital appreciation occurs due to the multiplication of a number of holdings.
Whether to choose Dividend Option or Growth Option
When caught in two minds regarding the choice of options, these factors may come handy:
1. Preference of wealth accumulation or regular income
Whether to go for dividend option or growth option reflects the choice of an investor. It is primarily a choice between capital appreciation and regular income.
As a prudent investor, you need to pursue goal-oriented investing over ad-hoc investing. While selecting an option, you may be guided by your goals. If you happen to be an investor who has periodic liquidity needs from the investments, then dividend payout option would be an appropriate one. In that case, you should renounce your desire of wealth accumulation in a fast paced manner. Moreover, there may be times when the fund doesn’t declare dividends owing to lack of surplus. So, don’t keep all your income needs exclusively pinned to your mutual fund investments.
Conversely, if you are an investor who accords preference to wealth accumulation via appreciation in the value of holdings, then growth option is your thing. By renouncing the need of regular dividends in cash, you allow the fund to invest the same in profitable avenues. As a result, NAV of your fund keeps tending northwards. It eventually translates into higher capital gains when you will redeem units of the fund.
Even though your number of holdings may not increase, still you make money owing to increase in the value of your existing holdings.
2. Tax Efficiency
When you invest in mutual funds, you attract tax incidence on dividends as well as on capital gains.
Let’s consider the tax implications on dividends first.
The dividend received on equity funds would be tax-exempt in the hands of unitholder as well as the fund house. It implies that you need not include it in your total income while computing taxable income. However, in the case of debt funds, the fund house is obliged to pay a Dividend Distribution Tax (DDT). So, it deducts the DDT from the dividend declared and pays you dividend net of tax.
In the case of a tax on capital gains, the period of holding is brought into consideration. Capital gains occur when the value of holdings have surged at the time of redemption as compared to the time of entry into the scheme. Suppose you held units of equity fund worth Rs 2 Lakh at the time of purchase. After one year, when you want to redeem, your holdings stand at Rs 3 Lakh. It means that the difference amount of Rs 1 Lakh would be treated as a capital gain for the investor.
Tax rates are different for short-term and long-term and for equity funds & debt funds. In the case of equity funds, holding period of less than 1 year is regarded as short term, and capital gains would attract 15% tax. However, if you sell your investments after one year, you need not pay any tax on capital gains.
In the case of debt funds, holding period of less than 3 years is regarded as short term, and capital gains would attract tax as per your income bracket. However, if you sell your investments after 3 years, you need to pay tax on capital gains at 20% after considering indexation.
The table given below presents an overall tax incidence of equity funds & debts funds:
3. Mode of Investment
You may invest in mutual funds via lump sum mode or SIPs. The manner of investment would affect your choice of option, i.e., growth or dividend.
If you are going into lump sum mode of investment, then you may opt dividend option to get a regular income. On the contrary, it would be unwise to go for the same in the case of SIP mode of investment. When you invest via SIPs, you need to prefer the growth option as it will help you achieve upward NAV movement.
Every mutual fund will have a different set of objectives. While examining the features and options of the funds, keep your financial goals and tax planning in mind. Always invest in a fund that suits your individual needs of growth or cash payout.