My cousin (Ankit) recently decided to invest in mutual funds, he was baffled to see so many options available. There were about 40 mutual fund houses available and over 2000 fund schemes. Further to this, he had to choose between growth, dividend pay-out or reinvestment option.
When you decide to invest in mutual funds, you are faced with a plethora of options. Each type of fund has its own advantage and disadvantage. The choice you make depends on your individual needs and attitude as an investor. The selection of the type of fund is as important as selecting the mutual fund itself.
Growth option is more suited for long term investing. Investments made under growth option do not yield any short term or monthly returns.So if you have purchased 500 units at 10 and sold it after a year at 15, your capital gain would be ₹2500 (15-10 = 5 * 500 units). Growth option doesn't pay you any dividends. If a fund appreciates then the NAV of the growth fund will increase accordingly. For example, if Ankit had a MF growth fund at ₹10 and it appreciates by 5%, then the NAV of the fund will increase as ₹15.
- Equity mutual funds are prone to risks in short term, but in long term, they have shown good performance.
- Growth option benefits from the power of compounding – your investments as well as your profits are compounded over long term thus giving you maximum income.
- No periodic income.
Investors choosing this option will get pay-outs in the form of dividends. A part of the profit from the fund is paid to you periodically. Over the period of holding, the investor will profit moderate raise in capital with some dividend returns. Due to these pay-outs, the power of compounding does not yield as much benefits as in growth scheme.
- Dividend scheme is ideal for short term investments and they provide a steady income along with capital rise, esp. in debt mutual funds.
- Dividends are not always assured. In some cases, zero dividends are declared throughout the year.
- The NAV of the unit falls by the amount the dividend is declared so your own money is paid back to you. Let's say you have a fund that has a NAV of ₹50 and a dividend of 10% is declared. So you earn ₹5 as dividend but your NAV will fall from ₹50 to ₹45.
In this plan, the dividends are declared but not physically paid. Instead they are invested back into other mutual funds. So you end up with additional units in your portfolio. These additional units are equal to the dividends declared out at the existing NAV.
- Dividend reinvestment is quite similar to growth option as you acquire large number of units at a lower NAV which is same as investing in fewer units having higher NAVs under growth option.
- You may have to pay an entry fee each time the dividend is reinvested. Also your reinvestments will be subject to lock according to the plan they are invested in.
According to present day laws, equity funds are taxed at 10% if they are held for long term and debt funds are taxed at 20% with indexation benefit. Dividend pay-outs are tax free in the hands of investor but the capital gains are taxed according to their holding periods and type.
|||Short Term Capital Gain Ta||Long Term Capital Gain Tax |
|Equity Mutual Funds||15%||10%|
|Debt Mutual Funds||As per investor tax slab||20% after indexation|
Dividends that are reinvested would be considered as capital for taxation purposes and therefore are taxed indirectly. But ELSS mutual funds and dividends that are reinvested in ELSS funds are eligible for tax deduction under section 80c.
Note: although dividends are tax free in the hands of investors, the fund houses will have to pay a dividend distribution tax, which will have an impact on the returns.
How to choose:Your tax bracket and your need for periodic cash-flow are the main deciding factors. In simpler terms,
- If you are looking for short term funds, periodic and tax free income – choose Dividend option
- If you are planning to create wealth or meeting specific goals over long term – choose growth option.