Your mutual fund investment, irrespective of whether it is an equity fund, or a debt fund offers you a variety of options. Broadly, there is the Growth Plan, Dividend Plan and the Dividend Reinvestment Plan. There are differences between these plans in terms of the liquidity management and in terms of the tax treatment. That takes us to the next key question on how one should select the best option. Let us look at the following criteria.
What are these plans all about?
Growth plan is the most basic kind of a plan where nothing is paid out to the unit holder. Whatever dividends are received, or capital gains are accrued remain in your fund and therefore the growth plan NAV increases consistently with the market. A dividend plan pays out dividend to the unit holder in cash. This is useful if you are looking at mutual fund investments for regular income. The NAV of your fund will reduce to the extent of the dividend paid out. A dividend reinvestment plan is a hybrid plan that has features of the growth plan and the dividend plan. In the dividend reinvestment the declared dividend is not paid out in cash, but they are reinvested in the units of the same fund. In case of dividend plans and the dividend reinvestment plans of Debt Funds, the dividend paid out attracts a dividend distribution tax (DDT) of 28.33%.
If the Equity Fund is part of your long-term financial plan.
The normal strategy is to prefer equity funds for long term financial planning. Equity funds entail risk, but they also give higher returns and hence the power of compounding results in tremendous wealth creation over a longer period of time. What plan should you choose when you are looking at equities as part of your overall financial plan? Let us consider the dividend plan first. Regular dividend payouts will result in money being regularly drawn out from your corpus. Any payment of dividend results in reduction of NAV and unless it is reinvested at a good rate of return, the purpose of financial planning is defeated. So, will a dividend reinvestment plan make sense? Theoretically, a dividend reinvestment plan is exactly like a growth plan, with a small difference. Hence a growth equity fund will be simpler and better suited for your long-term financial planning.
What about a tax saving ELSS scheme?
An ELSS is exactly like an equity fund, the only difference being that it comes with a lock-in period of 3 years as it also offers additional tax benefits under Section 80C of the Income Tax Act. So which plan should you choose? Since ELSS funds have a 3-year lock-in period, most investors may be uncomfortable without the liquidity. Hence, a dividend plan may give a good option for those investors who are looking to monetize some of the returns each year. In case you are not looking at liquidity, you can either look at a dividend reinvestment plan or at a growth plan. However, a growth plan should be preferred. That is because when dividends are reinvested the date of reinvestment will be the date of investment and the 3-year lock-in period will be calculated from that date onwards. Thus, growth plans will be more efficient.
What about choosing plans when it comes to debt funds?
In case of debt funds, the difference between the schemes becomes more critical as the debt fund dividends attract DDT of 28.33%. This largely changes the economics of the dividend plans versus the growth plans. Also, in case of debt funds and liquid funds there is a difference in the calculation of capital gains tax. In case of debt and liquid funds, long term is defined as 3 years’ time frame, short term gains are taxable at a higher rate and long-term gains are not tax free. So, how does this change the economics of choosing the plans?
If you are looking at regular income flows from your debt fund, then you can opt for the dividend plan and structure it as a systematic withdrawal plan (SWP). This will also be tax efficient as selling your fund in less than 3 years will attract your peak rate of tax. If you are not looking at regular income, then there are 2 options in front of you.
Option 1: If you are holding period is less than 3 year then you will better off with a dividend reinvestment fund. That is because the dividend reinvestment attracts a tax of just 28.33% while capital gains on a growth plan will be taxed at the peak rate of 33% as short-term gain.
Option 2: If your holding period is more than 3 years then you can get the concessional rate of tax of 10% without indexation or 20% with indexation on the growth fund. Thus, a growth plan will be more efficient in case your holding period in the debt fund is more than 3 years.
Effectively, you need to choose your MF plan according to your unique liquidity needs and your tax status. Typically, for the long-term holdings (as in case of your long term finance plan), the growth plan offers the best alternative.