When you invest in mutual fund (MF) schemes, you will, in most cases, be better off choosing its growth plan option over its dividend plan. Here’s why.
If your goal is to generate wealth for the long-term, growth plans can help you do this far better than dividend plans. In growth plans, the gains made are re-invested into the scheme and so, your investment can potentially grow and compound automatically over the long-term. On the other hand, in dividend plans, the gains made by the scheme may be paid to you as dividends. So, the gains do not get re-invested into the scheme, and compounding does not happen automatically. You can use the dividends received any way you wish – for expenditure or for re-investing in an instrument of your choice. Unless you re-invest, your wealth does not compound.
Note that in MF schemes, dividends are paid only from the gains made on the investment. Essentially, money belonging to investors is returned to them. So, the net asset value (NAV) of the dividend plan unit falls to the extent of the dividend declared. For instance, if the NAV of a MF unit is ₹25 and it declares ₹3 as dividend, the NAV in the dividend plan falls to ₹22 while it remains ₹ 25 in the growth plan. Going forward, in the dividend plan unit, ₹22 is re-invested while in the growth plan, ₹25 is re-invested.
Tax efficiency
Even if your goal is regular income receipts from your MF investments, dividend plans are not the way to go. One, the dividends are not assured. It is up to the mutual fund scheme whether to declare dividends or not. A MF scheme can declare dividends only from its distributable surplus. There may be times when a scheme is going through a rough patch and might not have enough to distribute as dividends. Even if times are good, the fund house is under no obligation to declare dividends.
Next, dividend payouts by MF schemes fare poorly on the taxation test; and the investor bears the brunt. Dividends on equity-oriented MFs are subject to dividend distribution tax (DDT) of 10%. Add surcharge (12%) and cess (4%), and the effective rate of DDT is about 11.65%What this means is if an equity fund scheme declares ₹100 as dividend, it has to pay tax of ₹11.65 and give only the balance (₹88.35) to the investor. Now, while the investor gets only ₹88.35 as dividend in his hand, the NAV of his dividend plan falls by ₹100. On non-equity oriented MF schemes, the DDT is 25%. Add surcharge (12%) and cess (4%), and the effective DDT rate is a mighty 29.12%.
Now, compare this with the tax on gains from sale of MFs. In the case of equity mutual funds, gains on sale of units held for 12 months or less are considered short-term capital gains (STCG) — this is taxed at 15%; including cess, the tax rate is 15.6%.
Long-term capital gains (LTCG) on sale of equity funds (held for more than 12 months) are taxed at 10%(10.4% including cess). But LTCG on listed equity and equity funds up to ₹1 lakh a year is exempt from tax.
If you plan to hold your equity fund for 12 months or less, the dividend plan is better than the growth plan since dividends will be taxed at a lower rate (10.4%) than the STCG (15.6%). But if you plan to hold the equity fund for more than 12 months or longer periods — this is usually recommended — the growth plan will, in most cases, score over the dividend plan. Since LTCG on equity funds up to ₹1 lakh a year is exempt from tax, the tax outgo will be lower. Also, if you can calibrate your redemptions and restrict the LTCG in a year to ₹1 lakh, you can avoid the tax completely.
On non-equity MFs, gains on sale of units held for 36 months or less are considered STCG — this is taxed at the investor’s slab rate (5, 20 or 30%, plus cess). LTCG on sale of such funds (held for more than 36 months) are taxed at 20% (20.8%, including cess) after indexation benefit. Indexation means increasing the cost of acquisition of the investment to account for inflation; this effectively reduces the LTCG amount and lowers the tax.
The takeaway here is growth plans invariably score over dividend plans in non-equity funds.
That’s because on STCG in non-equity funds, the tax rate for most investors (5.2% or 20.8%) is lower than the DDT (29.12%). For investors in the highest tax slab (31.2%) looking to sell within 36 months or less, dividend plans may be somewhat better but the difference between the tax rates is not much.
For investors who will be holding non-equity funds for more than 36 months, the growth plan is a clear winner since the tax rate on LTCG (20.8% after indexation) is lower than the DDT (29.12 %).
In both equity and non-equity plans, the entire amount of dividends are taxed while only the gain portion on sale of investments is taxed.
If you seek regular income from your MFs, it is better to go for the systematic withdrawal plan (SWP) option — after 12 months in equity funds and after 36 months in non-equity funds — to qualify the gains as LTCG. This will optimise your tax outgo and also give you certainty of cash flows.
