Growth or Dividend: Which is a better option for you?
Hemant Rustagi January 19, 2015Being an efficient and tax-effective product, mutual funds have expanded the investment universe for retail investors having different risk profiles and time horizons.
In addition, investors are also benefiting from the flexible and simple options available to them. It is, however, imperative that proper care is taken at the time of investing.
If one follows certain basic principles of mutual fund investing, the chances of success improve considerably. Besides, having the right allocation in equity and debt funds helps in achieving different investment objectives over varying time periods.
It is heartening to see a marked improvement in the quality of the decision-making process, thanks to the initiatives taken by the mutual fund industry and the emergence of a new breed of quality advisors.
The number of investors participating actively in decision making has been increasing steadily.
Of course, one still comes across instances where wrong choices cause disappointments in the form of failed investment objectives.
Over the years, the principles and techniques of investing in mutual funds have undergone a sea change. One of the key decisions that investors are required to make is to select the right option in a scheme.
In fact, it is as important as selecting the right fund. Mutual funds usually offer three options to investors, including growth, dividend payout and dividend reinvestment.
Knowing each option and choosing the one that suits you best is important.
First let us understand the "growth option". Here, a fund does not declare dividend and the net asset value (NAV) is allowed to grow. However, the NAV may fluctuate depending on how the markets behave from time to time.
Tax incidence under this option depends on the period for which the money remains invested. Moreover, tax liability arises only when you decide to redeem your holdings.
According to existing tax laws, for equity and equity-oriented balanced funds, i.e. funds that investment 65 per cent or more in domestic equities, short-term gains, i.e. gains made on investments redeemed with in 12 months, are taxed at a flat rate of 15 per cent. Long-term capital gains, i.e. gains on investments redeemed after 12 months, are, however, not taxed.
While growth option can be described as an ideal choice for long-term investments as it offers the benefit of compounding, in reality, many investors are wary of opting for it.
This is primarily due to their not-so-happy past experiences, wherein they saw the NAVs touching new highs only to plummet when the stock market spiraled down.
Therefore, they believe that dividend payout, i.e. an option wherein the fund declares and pays dividend as and when it has distributable booked profits, is a better option as it allows them to take some money out.
The fact, however, is that for someone who invests to achieve his or her long-term investment goals, such as children's education and wedding expenses, and their own retirement planning, the growth option remains the best bet because the compounding effect helps in building a large corpus.
In the long run, a combination of well-defined investment time horizon and a disciplined approach to investing through systematic investment plan (SIP) not only helps in tackling volatility, but also turns it into an advantage. Of course, for those investors who may like to either book profits periodically or receive some income by way of dividends, say, once in a year, or so, the dividend payout option would do the job.
It is important to know that dividends paid by equity and equity-oriented balanced funds are tax-free.
However, debt-oriented funds, i.e. funds that have an exposure of less than 65 per cent in equities, have to pay Dividend Distribution Tax (DDT) before paying out the dividend to investors. However, investors are not required to pay any tax on dividend received from debt funds. For individual investors, the DDT is 28.32 per cent (inclusive of surcharge).
Investors must know that for debt funds, any gain on units redeemed within three years is treated as short-term capital gains and is taxed at one's applicable tax rate. For example, an investor in the 30 per cent tax bracket has to pay 30 per cent tax on short-term capital gains.
However, any gains on units redeemed after three years is treated as long-term capital gains and is taxed at 20 per cent after indexation. Indexation benefit reduces the tax liability to a large extent and, hence, investors pay nominal tax on long-term capital gains.
Keeping these provisions in mind, investors in the tax bracket of 10 per cent and 20 per cent should opt for the growth option, if they intend to invest in debt-oriented funds for less than three years. For investments for three years or more, the right option would be "growth".
For investors in the 30 per cent tax bracket, dividend payout would be a better option for investments made with a time horizon of less than three years, whereas for three years and above, growth option would be ideal.
Now let's talk about the dividend reinvestment option. While the first part, i.e. dividend payment is exactly along the lines of dividend payout, the end result differs completely because instead of paying the dividend amount to the investor, it is reinvested in the same fund.
While this option has the combined features of dividend as well as growth option, it negates certain advantages.
For example, for an investor who has opted for dividend reinvestment in an equity fund, the fund will pay the dividend at a particular market level and the same will be reinvested in the fund at the same market level, thereby, defeating the main purpose.
Besides, one has to keep the dividend amount invested at least for a year to make it tax-free again. On the other hand, if one opts for the growth option, any withdrawals after one year are exempted from capital gains tax.
Therefore, one can plan redemptions for various purposes without having to worry about capital gains tax.
In other words, the toss-up should be between dividend and growth option. Therefore, consider various aspects relating to tax, rebalancing and time horizon before making a final call.