The question of investing in mutual funds is a no brainer, especially for those of you who want to achieve your financial goals (i.e. Everyone!). However, even after selecting the right fund for you, assessing your risk appetite, and making the optimum asset allocation, there remains the question of whether to go in for the growth option or the dividend option. This confusion is further compounded with the dividend re-investment option. The selection of the option is as important as the selection of the mutual fund itself. Let us take a look at these options in more detail.
Investments made under the growth option will not yield any short term income, in the sense that all money invested will continue to be invested until redeemed - i.e. this will give you capital appreciation and hence returns, but not regular (e.g. Monthly) income. For example, if you purchased 1,000 units of a mutual fund at Rs. 11 and sold it a year later at Rs. 15, this difference of Rs. 4,000 (i.e. Rs. 15 - 11 = Rs. 4 * 1,000 units = Rs. 4,000) is your capital gain and returns on investment.
This type of investment is more suited for long term investing in equity mutual funds, as there are no taxes on long term capital gains. Also, equity mutual funds are prone to short term risk, but in the long term they typically give good returns. This option benefits from the power of compounding since not only is the principal invested, but also the notional profit. It is a good option for those who do not need to depend on a monthly income from their investments for their living.
Also, since the fund does not pay out any dividends the NAV is much higher than that of the dividend option for the same fund - however it is to be noted that this difference is only due to the payment of dividends and not due to a substantial variation in the fund performance.
Unlike the growth option, investors opting for the dividend option will get a payout in the form of dividend. This option is ideal for short term investments, especially in debt. Debt mutual funds with dividend options are a good option for senior citizens who require a steady income flow and not only capital appreciation.
This option will give the investor the benefit of moderate capital appreciation along with dividend returns over the period of holding. It is important to note that due to the payouts, the power of compounding is not as efficient as compared to that of the growth option. Also, investors who do not depend on the dividend income, will face the risk of re-investment, i.e. re-investing the money earned via dividend in an asset class which offers good return.
It is important to keep in mind that dividends are not guaranteed, and also that sometimes no dividend is declared throughout the year.
Dividend re-investment option
This option tries to make the best of both worlds, in the form of declaring dividends to investors, but not issuing the dividends in the form of cash but re-investing the dividends into the same mutual fund for additional units. One faces the risk of having to pay an entry load each time a dividend is reinvested, and also if there is any lock in (as in the case of an ELSS), the new units will be subject to a further 3 year lock in. The growth option is a better bet than the dividend reinvestment option.
Taxation on growth funds is simple, as only capital gains are calculated, and for equity funds there is no tax on long term capital gains, while for short term capital gains it is 15%. In the case of debt funds in the growth option, short term capital gains is taxed at 30% whereas Long term capital gains is taxed at 10% without indexation or 20% with indexation. However, in the case of dividend options, the dividend is tax free in the hands of the investor, but the fund will have to pay dividend distribution tax before it gives the dividend.
1) Growth option will not pay out any interim dividends, and purely gives capital gains
2) Growth is best for long term, and for equity investments
3) Dividend option will give irregular payouts, and these are tax free in the hands of the investor
4) Dividend options are best for short term debt funds