One of the advantages and also challenge with mutual funds is that you have a plethora of options. There is the choice of fund portfolios. Then there is choice between active and passive approaches to investing. You can also select between Direct and Regular options depending on how much support you are looking at from the broker. Finally, there is the all important classification between growth plans and dividend plans. Of course, there is also a third plan called the dividend reinvestment plan, but that is not popular as it offers very limited additional advantages. So the two most popular plans are the Growth plans and the dividend plan.
Let us look at a growth plan and a dividend payout plan. The difference is quite straight forward. In a growth plan, the fund does not payout anything to the investors by way of regular payouts or dividends. All the profits of the fund are reinvested in the fund and so your wealth compounds automatically. When it comes to long term wealth creation, the growth plan is o auto mode. Dividend plans, on the other hand, pay out dividends but only out of the profits earned and income generated. Even a dividend plan is not permitted to pay dividend out of capital. While growth plans give you compounding, dividend plans give you regular income. Which should choose? Let us first see if they are really different structurally?
At a gross level, the wealth effect is the same in both cases..
The wealth effect comparison between the Growth Plan and the Dividend Plan of Alpha Equity Fund can be depicted as under:
ParticularsAlpha Equity Fund (Growth Plan)ParticularsAlpha Equity Fund (Dividend Plan)NAV of Fund (01-Jan-17)Rs.100NAV of Fund (01-Jan-17)Rs.100NAV in Oct-17Rs.118NAV in Oct-17Rs.118Dividend PaidN.A.Dividend PaidRs.3NAV post dividendRs.118NAV post dividendRs.115NAV in May-18Rs.127NAV in May-18Rs.124Dividend PaidN.A.Dividend PaidRs.3NAV Post DividendRs.127NAV Post DividendRs.121LTCG in May 18Rs.27LTCG in May 18Rs.21
At the gross level (remember the word gross) wealth effect is the same in case of the growth plan and the dividend plan of Alpha Equity Fund. The Growth plan has generated Long Term Capital Gains (LTCG) of Rs.27, whereas the Dividend plan generates capital gains of Rs.21 but it has already paid out Rs.6 as dividends to the investor. So, the wealth effect is Rs.27 in both the cases, although the nature of payout has been different. If they are structurally same, they what is there to choose between the two plans. Actually, three points are critical here.
1. The answer could actually lie in a pre-tax to post-tax comparison
When the mutual fund pays out dividends, it is tax free in the hands of the investors. However, the fund will deduct Dividend Distribution Tax (DDT) at the rate of 10% from the dividends distributed and only pay out the net amount. In case of growth plans it is classified as STCG if held for less than 1 year and taxed at 15%. If the investment period is less than 1 year, the dividend plan does appear to be more useful. But, in case the fund is held for longer than 1 year then it becomes LTCG and is taxed at 10% only if the gains are above Rs.1 lakh. This makes the growth plan more suitable for small and medium investors. If you look at debt fund, the dividends attract DDT at 29.12% including surcharge and cess. Relatively, if debt funds are held beyond 3 years they are just taxed at 20% with the benefit of indexation. This brings the effective tax rate on debt funds to below 10%.
2. Since growth plans compound, they fit better into your long term plan
This is an area where growth plan really scores over the dividend plan. When fund regularly pays out dividends out of profits the NAV reduces to the extent of the dividend paid out. Now, it is OK if you reinvest the dividends at the same yield, but that is more theoretical than practical. In practice, you don’t reinvest but spend your dividends. That is wealth depleting. Growth plans are auto compounders, since the profits are automatically reinvested by the fund. This plays a big role in long term wealth creation. The power of compounding works best in case of growth plans. Financial planning is all about pegging your SIPs to specific goals. A growth plan ensures that you can estimate returns more credibly and hence long term wealth creation becomes more predictable. This makes growth plans more aligned with long term financial planning.
3. I need dividends for my income post retirement; what do I do with growth plans?
When you are retired and looking for regular income, your risk appetite is certainly low. You cannot afford to take on too much risk and hence you prefer to invest in debt funds or liquid funds. The DDT is much higher in these cases because 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). A more intelligent method would be to structure the payout in the form of a Systematic Withdrawal Plan (SWP) so that you are only taxed on the capital gains component and not on the principal component. That would work better than a dividend plan.
Investors are increasing veering towards the merits of a growth plan in the long run. With a flexible approach possible in mutual funds, structuring is your key advantage.