What is the difference between “Growth and Dividend Option in Mutual Funds”? Why some people prefer Growth Option, while others prefer Dividend Option, in Mutual Funds?
You are often seeing the advertisements from Mutual Fund companies regarding the announcement of Dividends. Agents will use this as an opportunity to sell such Funds at that time showing Dividends as an extra payout. What is the truth in Mutual Fund Dividends? Is it really attractive?
Before understanding the Growth and Dividend Options in Mutual Funds, let us understand Mutual Fund basics.
Mutual Fund basics are very easy to understand. In this article, I will try to explain Mutual Fund basics by relating a simple story which will help you to understand Mutual Funds in a better way.
The Elite 500 Club was having their monthly meeting as usual. Members were discussing a common problem which they were facing. Each of them had small savings every month, but they did not know how to make the best use by investing it. The Club decided to form a Committee of 3 members who would solve this problem.
At the next monthly meeting, the Committee proposed a solution. They suggested pooling their savings, investing it under the supervision of the Club and dividing the gain among the investors. All members welcomed the idea. The members asked: Where would you invest the money? The group had some knowledge that the money will give good returns if invested in shares but had a faint idea about equity investment. Somebody recommended investing in chits. But overall, no one had the knowledge, so they decided to contact a wise man in the city who was well-versed in the field of investments. The wise man accepted the challenge and came to the meeting the next month.
But some members had doubts about this idea. Firstly, who would keep a check on the wise man and how would they know that their investment is making money or running into losses. The concerns were genuine and again the Committee started thinking. They came out with a set of general rules on investing the money. The wise man had to take a prior approval from the Committee before investing. But the second concern still remained, which was solved by the wise man himself. He said that each day he will calculate and declare the value of the investment.
The scheme was launched and it was an instant hit. The news spread to other clubs. People from other clubs were also allowed to join. Soon the Committee realised that they had to manage the records of so many people and solve their queries. They appointed a team of experts – Record Keeping Team whose job was to keep the record of investors and handle the investor queries. Similarly, a team was appointed to help the wise man in ensuring the safe custody of shares and other investments.
Till now, the Club was handling all the related jobs and paying salaries. But now that the scheme was a hit, the Secretary told the Committee to charge a fee from the investors to pay for the wise man and the other employees. This was a good idea. The Committee laid the rules for charging the fees on the investments. All the participants benefited in the long-term through this collective investment.
This is exactly how a Mutual Fund works.
Now let us understand the Mutual Fund basics in technical terms.
Mutual Fund Basics – Technical Terms
In the above story, the members of the Club are the Investors like us, and the Committee is the Asset Management Company (AMC), who runs the entire affairs of the Mutual Fund. Since this Committee is appointed and answerable to the Club, the Club is the Sponsor of the Mutual Fund. The Wise man appointed, is the Fund Manager. The Rules laid are the Objectives, which are set for each Mutual Fund Scheme. The Value of investment that the Wise man is reporting is helpful in calculating the Net Asset Value (NAV). NAV is the unit value of the asset and is calculated by dividing the net assets by the numbers of unit holders. The Record Keeping Team is Registrar & Transfer Agent. And finally, the team appointed for ensuring the safe custody of investments is called the Custodian. The fees that the scheme is charging are called the Asset Management Fees.
Benefits of Investing in Mutual Fund
The biggest advantage is Diversification. Each unit holder contributing in small proportion becomes a part-owner of a large portfolio. This minimises the risk by dividing the investments into many securities.
Through Mutual Fund, you get expert management for your investment and you can invest in small amounts. Since this is a collective investment, the cost of the management is very low and most important is the liquidity aspect. You can invest a fixed amount regularly (SIP) and save for your long-term goals. This concept of Rupee Cost Averaging will help you in averaging your cost of buy and which has given good returns in the past.
Also from the taxation point of view, Mutual Fund scores over other investments. Profits from the sale of Equity Mutual Funds after one year from the date of investment are considered as long-term capital gains and are tax-free.
There are many types of Mutual Funds in the market to confuse the investors. Your success lies in identifying the right fund and investing in it.
Now, let us study the Growth and Dividend Options in Mutual Funds.
Growth Option in Mutual Funds
While investing in a Mutual Fund, if you opt for the Growth Option, you are not eligible for any dividend. But the gains made by the Fund will be reflected in the value of your investment by way of higher NAV. This is the reason why NAV of the Growth Plan is higher than the Dividend Option. You can enjoy such gains only when you sell the Fund.
Dividend Option in Mutual Funds
In this option, you will be paid dividend out of the profits made by the Fund. But the declaration of dividend is at the discretion of the Fund House and is not guaranteed. Dividends are often declared as a percentage on the face value of the units. Imagine, the current NAV of a Fund is 20 and it declares a 20% dividend today. It means an amount of Rs. 2/- per unit will be paid to you. (20% of the Face Value Rs. 10/-). But after the payout of this dividend, the NAV of the Fund will fall to Rs. 18/-, which is called the ex-dividend NAV. So, in this case, you are not getting anything extra compared to the investor, who has opted for the Growth Option.
The dividend in Mutual Fund is not an extra benefit paid. The amount paid as dividend is reduced from the NAV immediately. So, it is nothing but, returning a part of your own investment. You will feel happy because you are getting that amount in hand, but to that extent, your savings is reduced.
Growth and Dividend Option in Mutual Funds – How to choose?
You should select the option, as per your financial goals and in line with your cash-flow planning. For long-term goals like your retirement, child education and their marriage, opt for Growth Option to get the benefit of compounding. If you opt for Dividend Option, the dividends paid will reduce the NAV and you may not get the desired amount for the long-term goal.
But, if you are looking for some cash-flow from your investments, then you can opt for Dividend Option. But please note, that there is no fixed frequency of payments in Dividend Option. The Fund House will decide the amount and the date of the dividend.
Growth and Dividend Option in Mutual Fund – Taxation
The taxation rules are different for Growth and Dividend Options.
Equity Mutual Funds
As per the current tax laws, Long-term Capital Gains from Equity Mutual Funds are tax-free. The gains are treated as long-term if you have invested there for more than 1 year. It is better to opt for Growth Option and get the benefit of tax-free capital gains if your investment horizon is more than 1 year.
But, the Short-term Capital Gains will be taxed at 15%, if you are selling the Equity Mutual Funds within 1 year. So, in this case, it is better to go for a Dividend Option, because the dividends are tax-free. There is no Dividend Distribution Tax in Equity Mutual Funds.
But investing in Equity Mutual Funds for a 1-year horizon is highly risky and it’s better to avoid.
Debt Mutual Funds
Dividends received by you from Debt Mutual Funds are tax-free, but there is dividend distribution tax (DDT), paid by the Fund House before declaring the dividend. The rate of DDT is 25%. There is a surcharge of 10% and Education Cess of 3% on it, which makes an effective tax rate of 28.325%.
In the Growth Option, the taxation is different. If you redeem your investment after 1 year, the gains will be treated as long-term and will be taxed at 10% without indexation or at 20% with indexation. Indexation will help you to offset the effect of inflation and the tax liability will be reduced, in periods of high inflation. Growth Option will be better if the duration of investment is more than 1 year.
But if you sell your Debt Mutual Funds within 1 year, the gains made will be treated as Short-term Capital Gains and you have to pay tax on it as per your Income Tax slab. If you are in 30% tax slab, you have to pay 30% tax on such gains.
Growth and Dividend Options in Mutual Funds – Which is better?
By now, you are clear about the difference between the two Options. Now, which option is better?
Since Mutual Fund investments are for long-term, it is better to opt for the Growth Option both in Equity and Debt Mutual Funds. Dividends paid by Mutual Funds are not like Dividends paid in Shares. Mutual Fund Dividend is nothing but the partial withdrawal of your money, at the discretion of the Fund House!