When an investor invests in mutual funds, there are three options to choose from – dividend painvestort, dividend reinvestment and growth. The most suitable option for investor is to decide the gains earned are treated under each option for taxation and other purposes.
While mutual funds are amongst the most rewarding investments over the long term, in order to make the most of them, investor needs to ascertain the appropriate fund for investment. This not only involves selecting a scheme that suits investor’s requirements, but also, within the scheme, the type of investment option that is in tune with investor’s needs. In other words, before investor invests in a fund, investor need to choose between the dividend painvestort, dividend reinvestment and growth option.
In this article we are trying to summarize the difference between each of these options and how do investor decide which alternative is best for him.
When a fund registers gains over a period of time, it may choose to retain these profits in the fund or it can declare a dividend. As the name suggests, under this option, the dividend that a mutual fund scheme declares is paid out to investor and the fund’s Net Asset Value (NAV) stands reduced to that extent.
This is a facility, where, instead of investor receiving dividend, the fund ploughs back the dividend declared into the scheme and investor get an equivalent additional number of units allotted to investor.
In case of the growth option, whatever profits the fund generates, is retained with the fund, and is reflected by an appreciation in the fund’s NAV.
Let’s understand the working of these options with an illustration. Assuming that an investor has invested Rs 1,000 in a fund at an NAV of Rs 10 per unit the total number of units held by investor is 100. The fund records an appreciation of Rs 2 per unit in its portfolio and declares this as dividend (i.e. it declares a dividend of Rs 2 per unit). Under the dividend option, investor will receive Rs 200 as dividend (Rs 2 x 100 units) and the value of investor’s holdings will be around investor investment cost i.e. Rs 1,000. In the dividend reinvestment option, the Rs 2 per unit declared as dividend, would be reinvested in the fund at the prevailing ex-dividend NAV, and investor would be left with 120 units worth Rs 10 each. Lastly, under the growth option, the appreciation will be reflected in the fund’s NAV, which will increase from Rs 10 to Rs 12. Thus, the value of investor holdings will be Rs 1,200 (Rs 12 per unit x 100 units).
The most superior option for investor is the choice between the dividend and growth option should be based on investor’s investment horizon, tax status and lastly, investor’s risk profile. If investor is among those investors who are looking at reaping benefits in the long run, then the growth option is just the right pick for investor. On the other hand, if investor wishes to receive regular cash painvestorts, then the dividend painvestort option will do justice to investor’s needs. However, it is important to note that it is not statutory for the mutual fund company to offer dividends regularly.
If investor invests money with a view to get a lump sum or build investor nest egg for the future, then investor will be better off with the growth option, as investor get the benefits of compounding. Under dividend option, there may be frequent dividend distributions, whenever the fund manager books profits and decides to distribute.
The best option while investing in mutual funds depends on investor’s requirements from investments, investor investing psychology and the existing fiscal policy in place.If investor do not need regular painvestorts then both, the growth or dividend reinvestment plan, would serve the purpose. However, if investor do need regular painvestorts for any commitments, then dividend option is best but keep in mind that fund houses pay dividends at their prerogative (that is only if a distributable surplus exists) and not the investors.
Besides, while investing in mutual funds, other than requirements and investment psychology, investor also need to take into account the tax angle. Investor does not need to pay any tax on dividends declared by equity funds under the dividend painvestort option. But returns earned by way of appreciation in the NAV on the growth option are taxed as capital gains. If investor holds units for less than a year, the returns will be taxed as short term capital gains. If investor holds for over a year, the returns are treated as long term gains. Tax implications on both these periods of holdings are different for equity funds and for debt funds.
So, the rational choice is where the tax liability hurts the least. Ideally, for tenures above one year of investment, the growth option would be advisable.
Investing in mutual funds can be a dicey business, if investor chooses to be ignorant or unaware. If investor learns to play simple rules, investor can go a long in reaping more profits.