Mutual funds in India offer the Equity plan, dividend plan and the dividend reinvestment plan. The dividend reinvestment plan is not very popular as it has little to offer extra. But there are enough believers in growth option or dividend options. That brings us to a basic question; should an investor prefer the growth option or the dividend option while investing in a mutual fund. The answer would be, “It depends”. What is growth option and dividend option in mutual fund and let us also understand the difference between mutual fund growth option and dividend option. Here are 5 key factors that will determine which is more attractive as an option for investors?
The dividend earned never gets reinvested
The most basic argument against the dividend plan is that you just receive the dividend and use it for other purposes. You rarely bother to reinvest the dividends. More often, you are quite happy with the intermediate flow and want to use it for some pending purchase. Remember, when a fund declares dividend it is paid out of the NAV of the fund. Therefore the NAV of the dividend plan will get reduced to the extent of the dividend. Let us look at the Alpha Equity Fund in the table below..
Dividend PlanAmountGrowth PlanAmountUnits Purchased10,000 unitsUnits Purchased10,000 unitsPurchase NAVRs.12 per unitPurchase NAVRs.12 per unitTotal InvestmentRs.1,20,000Total InvestmentRs.1,20,000NAV after 1 yearRs.18NAV after 1 yearRs.18Value after 1 yearRs.1,80,000Value after 1 yearRs.1,80,000Dividend DeclaredRs.4Dividend Declared0Dividend earnedRs.40,000Dividend earned0Post dividend NAVRs.14Post dividend NAVRs.18Final ValueRs.1,40,000Final ValueRs.1,80,000
In terms of wealth effect both the dividend and growth plans are the same. The dividend plan has taken Rs.4 out as dividend and therefore its NAV is Rs.4 lower than the growth plan. The problem is that if this Rs.4 taken out as dividend is not reinvested then you lose out on wealth creation.
Growth option is more compatible with long term planning
This is a sequel to the previous point. When you are planning for long term goals like retirement or your child’s education you need to ensure that the power of compounding works in your favour. That is only possible if the returns are constantly reinvested in the fund. If you opt for a dividend plan then most of your returns get consumed as dividends and hence your actual wealth creation will be that much lower. A growth option is an auto wealth compounder and hence it is more compatible when you are looking to compound wealth over the long term.
Problem of double taxation in equity mutual fund dividends
The big argument against dividend plans in equity funds is that it is not tax efficient. You may be surprised but even after considering that long term capital gains (LTCG) is going to be taxed at 10%, growth options are still going to make a lot more sense to you. That is because post the Budget 2018, equity funds will be subject to double taxation. The company will deduct dividend distribution tax (DDT) on the dividends it pays to the mutual funds. Then the mutual fund will again deduct DDT at 11.536% (10% DDT + 12% Surcharge + 3% cess) and only pay the net dividend to the fund holder. That literally amounts to double taxation for the investors and makes the entire dividend plan extremely tax-inefficient.
Debt Growth Plans are also more tax efficient
You may wonder that dividend plans may not make sense for equity funds but what about debt funds? Dividend plans would surely make more sense for debt funds. The answer is a clear “No”. That is because when a debt fund declares dividends then the dividend distribution tax (DDT) is deducted by the fund at the rate of 28.84% (25% DDT + 12% Surcharge + 3% Cess). On the other hand, if you are invested in a growth plan of a debt fund and hold the fund for more than 3 years, then it will be classified as long term gains. In that case, you pay tax at 20% with the benefit of indexation, which is more economical.
If you need regular income, then prefer SWPs
One can argue that if you opt for a growth plan then you do not get regular income. This is more so for retired persons who are relying on their debt fund portfolio to pay regular dividends to them to meet their routine expenses. The idea is that the debt fund pays a higher return than bank FDs and that acts as an added advantage. There is another solution to this problem. You can structure a Systematic Withdrawal Plan (SWP) in such a way that each month you withdraw a part of the capital and a part of the returns. You only pay capital gains tax on the return portion and not on the principal portion and thus it becomes more tax-efficient for you; at the same time ensuring regular income.
Generally, growth options are a better idea. Of course, in case you are particular about regular income, you can better opt for an SWP. That is like hitting two birds with one stone!