Mutual funds present an opportunity to investors to grow their wealth through investments in a variety of securities such as stocks, bonds, money market instruments, etc. They are professionally managed investment vehicles that pool the capital of many investors and then invest it in a variety of securities mentioned above. Mutual funds are preferred by many present-day investors due to their ability to deliver attractive returns when compared to traditional methods of investment like gold, bank deposits, etc.
When buying a mutual fund, investors are offered two options - growth and dividend. Investors need to understand that selecting the right option is as significant as choosing the right mutual fund scheme to invest in. However, many investors are not familiar with these terms and hence, for the benefit of those investors, we will explain what both these options mean, how they can affect your investments, and which one you should opt for.
What is the growth option in mutual funds?
When an investor opts for the growth option in a mutual fund, it would mean that the profits earned by the scheme will be invested back into it. This will lead to an increase in the Net Asset Value (NAV) of the scheme over time. In a similar fashion, there will be a drop in the NAV if the scheme were to undergo a loss.
By choosing the growth option, investors can maximise the NAV of the fund and achieve higher capital gains on the same number of units originally bought upon selling the mutual fund units. Suppose the investor purchases 100 units of a mutual fund scheme at an NAV of Rs.50 and chooses the growth option. If in 1 year, the scheme’s NAV increases to Rs.60, the investor can sell the units for Rs.6,000 and realise a profit of Rs.1,000 (Rs.6,000 - Rs.5,000) on the investment.
The growth option is ideal for investors who wish to compound their wealth to meet their long-term financial goals.
What is the dividend option in mutual funds?
The dividend option in mutual funds offers regular payouts to the investor from the profits earned by the scheme. However, there is no guarantee of the dividend amount and the frequency. Fund houses declare dividends only when the scheme achieves profits and this is done at the discretion of the fund house or the fund manager.
When an investor chooses the dividend option, the NAV of the units is not allowed to grow because the asset management company (AMC) pays out the dividends whenever the dividend amount reaches a certain point. Let’s assume that an investor buys units at an NAV of Rs.14 and chooses the dividend option. If the scheme’s NAV touches Rs.16 and the AMC decides to pay out a dividend of Rs.1.50, the investor will receive this amount but there will be a fall in the scheme’s NAV which in this case would be Rs.14.50.
The dividend option is ideal for investors who are retired and wish to receive a regular income.
What are the tax implications of both the options?
Equity-oriented mutual fund schemes did not attract any tax for the investor till the presentation of the Union Budget 2018 after which all AMCs were required to pay a Dividend Distribution Tax (DDT) of 10%. The AMCs deduct this amount from the dividend of the investor which means that if an investor was getting a monthly dividend of Rs.1,000, he/she will now receive only Rs.900.
On the other hand, growth plans attract a STCG tax of 15% if units are held for less than 12 months. However, if the units are held for more than 12 months, there will be no LTCG tax unless the gains are over Rs.1 lakh. There are fewer chances of annual returns for small and medium-sized investors to exceed the Rs.1 lakh mark and hence, such investors can enjoy tax benefits on the growth plans. Even in case of large investors, growth plans can be relatively tax efficient.
Which one should you choose? Dividend option or Growth option
As an investor, whether you choose the growth or the dividend option will depend on your financial goals. When you choose the dividend option, you may lose out on the compounding returns as no reinvestment of dividends takes place and consequently, the process of goal achievement may be slowed down. However, it may give you a good dividend amount at a time when the market is performing well. The dividend option also works best for retired people who are looking to receive a steady income from their investments.
The growth option, on the other hand, is suitable for investors who do not need a regular income and who are looking to invest over a longer term to achieve their long-term wealth creation goals. Since growth plans allow the invested capital to compound through reinvestment, the returns achieved in such plans are higher than in the dividend plans.
Can investors switch from the dividend to the growth option?
Yes. Switching from the dividend to growth option is possible but while doing so, investors should bear two things in mind. The first thing is the exit load that the fund house may charge for switching within the scheme, a different scheme from the same fund house, or a different scheme from a different fund house. Secondly, when a switch is done before 1 year, it will be considered as a sale transaction and hence, will attract a STCG tax of 15%. Investors need to keep these two things in mind before making a switch.