In any investment, the objective is to make money. Once this is taken care of, the second objective is how the individuals want to receive it. They can receive periodic returns from their investment; they can reinvest the returns in the same asset whenever it is paid; or they want to build the capital appreciation so that they can sell the investment in future and earn a handsome return on their investment.Thankfully, mutual funds understand this and they usually give all the three options. The options are dividend, dividend reinvestment, and growth.All these choices have different implication on cash flows and tax.
Understanding the options
Let’s understand the options and how they are structured.
Dividend option– Mutual funds with dividend options pay dividends periodically. Hence when the mutual funds generate money on investment, this money is paid back to investors in the form of dividends. The payment may happen monthly, quarterly or yearly depending on the structure of the fund. The objective of dividend option is to receive income periodically.
Dividend reinvestment option– In this case, the dividend that is supposed to be paid to the investor is reinvested in the mutual funds. This results in increased units of funds in the investors’ account. The units are bought at the prevailing NAV.
Growth option– Growth option doesn’t pay any dividend. The returns are reflected in the NAV of the fund. The objective of growth option is to build capital appreciation over a period of time.
Suppose you bought a mutual fund unit at the NAV of Rs 20. After a year, its NAV goes to Rs 25. In case of dividend option, the fund house may give some amount from returns (say Rs 2) will be given to the investor. In case of dividend reinvestment option, Rs 2 will be used to buy the units of the mutual funds. In case of growth option, there will be no action.
Impact on NAV
Usually, the NAV of a mutual fund comes down by the dividend amount. Hence in our example as mentioned above, the NAV of the fund will come down from Rs 25 by Rs 2. Hence the new NAV will be Rs 23. Rs 2 will be paid to the investor.
In case of dividend reinvestment option, the NAV will come down to Rs 23 and Rs 2 will be used to buy more units of mutual funds. Hence you will have more units of fund with a NAV of Rs 23.
In case of growth option, there is no payment or buying extra units from earnings. Hence the NAV will remain Rs 25.
Note: Mutual funds declare dividends as percentage of face value (usually Rs 10) of the fund. Hence if a fund has issued 50% dividends and the NAV is Rs 20, the dividend amount will be calculated on face value. Hence the dividend amount will be Rs 5.
Let’s take a look at UTI equity fund with both growth and dividend options.
UTI Equity Fund (G) – NAV = 54.40
UTI Equity Fund (D) – NAV = 48.09
You can clearly see that NAV of dividend option is lower than that of growth option. The reason is dividend that is paid to the investors and dividend reduces NAV.
Investors do not have to pay taxes on dividends. However, the fund pays a dividend distribution tax (DDT). DDT is 12.5%. Since Government policies on taxation keeps changing frequently, investors should check the current DDT. As far as funds with growth option are concerned, the taxation depends on the length of time the fund is kept before liquidation. If investors keep buy and sell within a year, there will be short term capital gain tax (STCG) will be applicable. If you sell after an year, the returns will fall under long term capital gain tax (LTCG).
The taxation again depends on fund types. For equity and debt funds, the short term gains attract taxes of 10%. Long term capital gain tax on equity fund is zero while it is 10% (without indexation) or 20% (with indexation) in case of debt mutual funds.
Now it really depends on individuals’ requirement. If you desire to get income periodically, you should opt for dividend option. If you are looking for long term wealth building, go for growth option. We have tried to give the most accurate taxation numbers. However, investors should check the most recent ones.