Insights

Should you choose the dividend option or the growth option?

March 15, 2013 . Vidya Bala
Your investment time frame, cash flow needs and tax bracket will decide whether you should go for dividend or growth options

“Should I go for growth option or take out the dividends in my fund?” – is a question frequently asked by many of you, when venturing into mutual fund investments. Before we move on to discussing what suits you best, let us get down to some brass tacks.

The difference
The growth option simply implies that the profits you make stay reinvested. In other words, the profits, along with your capital, are invested in stocks/debt to earn you more money.

Dividend payout implies that a part of such profits (an amount that the fund decides to give out) is stripped from your NAV and given to you. That means, a part of the fund’s profits are given in cash. Hence, your NAV falls to the extent of dividends. This is why the NAV of growth and dividend option are not the same.

In dividend reinvestment option too, profits are stripped. But instead of giving them as cash, they are allotted to you as units at the prevailing NAV. Hence, indirectly, by adding more units, you simply stay invested in the fund. Conceptually, the dividend reinvestment option is the same as growth option for all equity funds.

Two key factors will determine what is appropriate option is for you:
1. Cash requirement and time frame
2. Tax efficiency

Most people base their decisions on tax efficiency. While it is a key deciding criteria, let us also look at how other factors too, will play a role in choosing between dividend and growth.

Equity funds
Let’s take on the easy one first. Equity funds are meant for the long term. Your reason for choosing an equity fund must be to build wealth towards some goal which is perhaps at least few years away.

That simply means you should stay invested in the fund and not take the cash out (unless you will invest the dividends back diligently) to help compounding work for you. Since, long-term capital gains are free of tax, the solution here is simple: As a general principle, go for growth or dividend reinvestment in equity funds.

But there are exceptions: One, in case of theme funds or sector funds that you hold tactically, it makes sense to either opt for dividend payouts or book profits as the fortunes of themes can take a turn after one good cycle. Two, in case of ELSS, avoid dividend reinvestment as every reinvested unit will be subject to a three-year lock in. Prefer growth, Three, if you are generally risk averse and prefer to take your money out to invest in some debt option, then you should consider payouts or set triggers to book profits.

This category gets a bit tricky because the dividend suffers dividend distribution tax (DDT). DDT is nothing but the tax on the dividend paid out in debt and debt-oriented funds and gold funds. DDT is not applicable for equity funds.

Let us suppose a fund declares Rs 10 as dividend. A DDT of 28.33% ( 25% plus surcharge of 10% plus cess of 3% from June 1) is Rs 2.833. Now while you will get Rs 10 in your hands, Rs 2.833 will be further reduced from your NAV (your NAV after dividend will be – pre-dividend NAV minus dividend minus DDT).

Now, to know the tax implication Let us split your universe into two based on your cash needs:
1. You need some cash flows from your debt fund: In this case, you can choose the dividend payout or the systematic withdrawal plan (SWP) under growth option. Look at the table below. The SWP is a clear winner for those in the 10% and 20% tax brackets. But please ensure that you do not end up paying exit load. Opt for SWP post the exit load period if you wish to avoid the load.

dividend1

Those in the 30% tax bracket, can go for dividend payout, if you intend to hold the fund for less than a year.
But you do not gain much by doing so, as DDT will increase to 25% for all debt funds (earlier only for liquid funds) effective June 1.

But if you can park your money for more than a year and have no immediate cash flow requirements, opt for growth right when you invest and do a SWP from the beginning of the second year.

Remember, switching between options will also unnecessarily entail capital gains tax if you have profits. Hence, get your investment time frame right when you start your investment.

2. You don’t need cash flows from your debt fund: In this case, you have 2 options – to go for growth or dividend reinvestment. Look at the table below. Growth option scores in most cases, except when you are in the 30% tax bracket and redeem in less than a year.

dividend2

When you are in the 30% tax bracket and hold for less than a year (will be the case with most of your liquid or ultra short-term funds)  you will suffer DDT of 28.33% (including surcharge and cess effective June 1) on the dividend reinvested.

This will be slightly lower than the income tax slab of 30.9% (including cess).

Consider your fresh investments through the above routes. But if you make your switches now, do take into account the exit load(will vary for each fund) and the capital gains, if any, you may suffer on the fund now, especially if your holding period is less than a year and you do not have a long time frame for the investment from here on.

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