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Growth or Dividend : Mutual fund option perfect for you?

Last week, in the post on 'New improved personal finance investments', I had made a mention of the various options under a mutual fund scheme. Since this is still a grey area for many investors, a detailed write-up on the same would be quite useful. 

Fact 1A typical mutual fund scheme offers 3 variants viz.
- Dividend Payout
- Dividend Reinvestment
- Growth

Fact 2Most investors are not sure which variant to opt for.

Fact 3Given the experience with equity shares, "dividend" is presumed to be extra income; over and above the capital appreciation. Hence, most people opt for the Dividend Option (sometimes Payout and sometimes Reinvestment).

As a first step towards understanding whether Growth is a better alternative vis-a-vis Dividend or not, you should note that the above mentioned presumption is wrong. In mutual funds, dividends are not "something extra".

All the profits and gains of a mutual fund scheme — capital appreciation, dividend received from the companies in its portfolio, interest earnings or any other form of income — are added to the total corpus and hence reflected in its Net Asset Value (NAV = Total corpus / No. of units).

Therefore, when any mutual scheme declares a dividend, there is no separate kitty from where the same can be paid. The dividend money comes from the corpus itself. So whenever dividend is paid out, the corpus reduces to the extent of the total dividend amount. Consequently, the NAV too reduces. In other words pre-dividend NAV = post-dividend NAV + dividend declared.

In shares, the dividend is paid out of the profits, which is separate from the share capital listed and traded on the stock exchange. So, for shares, dividend is additional income apart from the capital gains.

This, in no way, makes mutual funds inferior to shares. Its just that the process of sharing profits is different. Return-wise there is simply no difference.

(As such, for mutual funds, I would rather call this as "income distribution" to the unit-holders. The word "dividend" creates an unnecessary confusion in the minds of the investors.)

Effectively, therefore, in mutual funds there is NO DIFFERENCE in your "basic" returns whether you opt for the Growth or Dividend option.

However, capital gains are taxed differently than dividends. Further, the tax treatment differs for
a) the period of holding i.e. short term or long term, and
b) the type of mutual fund scheme i.e. equity or debt

Hence, your choice of option i.e. Dividend or Growth will determine as to how much of this "basic return" finally comes into your pocket after paying the taxes. In other words, you have to choose your option carefully so that you pay nil or minimum tax on your gains. 

Different scenarios in this regard are presented below [for simplicity, I have ignored the applicable cess and surcharge].

1. Equity and equity-oriented mutual funds
Dividend : Nil Tax
Capital Gains : Nil Tax if holding period > 1 year (else 15% when holding period < 1 year)

Since, equity investments should ideally be held for many years (definitely not less than 1 year) and assuming you do so, it is immaterial whether you opt for Growth or Dividend. Both dividends and long term capital gains from equity funds are TAX FREE. 

Of course, for dividend, Reinvestment is a better option than Payout as you benefit from the power of compounding.

2. Debt and debt-oriented mutual funds, including international and gold funds
Dividend : 25% Dividend Distribution Tax
Capital Gains :  20% with indexation benefit if holding period > 3 years (else taxed per your slab rate when holding period < 3 years) 

Thus, depending on your tax status and holding period, you have to see where your tax outgo is the minimum.
                                   10%        20%      30%    
Less than 3 years         Growth     Growth     Dividend
More than 3 years               ---  Growth Option ---

(Note: Those in Nil tax bracket may stick to the traditional bank fixed deposits. Debt mutual funds may not offer them any significant advantage.)

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