Mutual funds offer two broad types of options – Growth and Dividend. There are several misconceptions about these options among lay investors. In the debate of growth vs dividend, some think growth option is better while others think that, dividend option is better. One option is not necessarily better than other. You should select the option which is more suited to your investment needs viz. financial objective and tax situation. In this article, we will discuss the difference between growth and dividend options and how they work.
Before you endeavour how to choose mutual funds, you must know the following 3 things -
What is dividend option?
In dividend option, profits made by the mutual fund scheme are paid out to investors at certain intervals. The most common dividend pay-out interval is annual. However, some schemes also offer other pay-out intervals e.g. daily, monthly, quarterly etc. Some schemes may offer multiple pay-out options. One type of dividend option is dividend re-investment option, whereby dividends paid by the scheme are re-invested in the scheme. Here are some important points to note about dividend option:-
- As per SEBI regulations, dividends are to be paid out from the accumulated profits of the scheme.
- There is no assurance about dividend pay-out rate or timing of dividend payments.
- The dividend paid to investors is adjusted from the scheme NAV. Therefore, you will see a drop in NAV (ex-dividend NAV) of your scheme after you receive dividend. In a dividend re-investment option, the unit balance goes up.
- Dividends paid by both equity and debt mutual fund is taxed in the hands of the investors at the applicable income tax slab rates of the investors. Income Tax Act provides for mandatory deduction of TDS @ 10% from dividend income in case of Resident Individual. However, no TDS is deducted if aggregate dividend distributed or likely to be distributed during the financial year to an individual unit holder does not exceed Rs 5,000. In the absence of Permanent Account Number, the TDS rate would be 20%.
What is growth option?
In growth option, profits made by the scheme are re-invested in the scheme instead of being paid out to investors. Since profits are re-invested in the scheme, you may earn profits on profit and thereby benefit from compounding. If you think, growth vs dividend, you should invest in growth option if you do not need regular cash-flows. Here are some important points to note about growth option:-
- The underlying portfolio of both dividend and growth options are exactly the same. When a fund manager books profit the impact is same in both dividend and growth option. The only difference is that, profits are re-invested in growth option and distributed in dividend option.
- The NAV of growth option will always be higher than the dividend option because the profits re-invested in the growth option may grow in value over time.
- The total returns of growth option are usually higher than dividend option over sufficiently long investment horizon due to compounding effect.
- From an investment perspective, growth and dividend re-investment options are exactly the same. However, taxation of growth and dividend re-investment options are different.
- There is no incidence of taxation in growth option unless you redeem. In equity funds, short term capital gains (held for less than 12 months) are taxed at 15% and long term capital gains (held for more than 12 months) of up to Rs 1 lakh are tax exempt and thereafter, taxed at 10%. In debt funds, short term capital gains (held for less than 36 months) are taxed as per the income tax slab of the investor and the long term capital gains (held for more than 36 months) are taxed at 20% after allowing indexation benefits.
Growth or dividend option – Key differences
Following is the the difference between dividend and growth option of mutual funds -
| Differences | Dividend Option | Growth Option |
|---|---|---|
| Profits booked by fund manager | Distributed to investors | Re-invested in the scheme |
| Net Asset Value (NAV) | Dividends paid are deducted from the NAV. So ex-dividend NAV is lower | NAV will be higher because profits re-invested may earn profits (compounding) |
| Total Returns | Total returns will be lower compared to growth option in the long term due to periodic payouts | Total returns will usually be higher compared to dividend option over sufficiently long investment horizon |
| Taxation | Taxed as per the income tax slab rate of the investor | Short term and long term capital gains tax applies depending on when you redeem |
| Who should invest | If you need regular cash-flows from your investment then you can invest in dividend option | If you do not need regular cash-flows, invest in growth option since your total returns may be higher |
Conclusion
We discussed how growth vs dividend works in mutual funds. We tried to clarify some difference between dividend and growth Even though the underlying portfolio of both the options are same, the only difference is in how the profit is distributed or re-invested. From a taxation standpoint, growth option definitely enjoys tax advantage especially over longer investment tenures. You should consider your tax situation when you select between the growth or the dividend option.
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