Building wealth is a process. Mutual funds allow you to choose from a wide range of funds and a range of options within the schemes. Even within the mutual fund category, there are options that you can choose from, depending on how you wish to treat your investment returns – you can choose to encash it, re-deploy it to purchase additional units of your investment avenue or choose not to receive it in exchange for a growth in the value of your investment. They are basically classified as – dividend payout, dividend reinvestment and growth. Let’s understand each plan separately:

Growth Vs Dividend Option in Mutual Funds: For every mutual fund scheme, mutual fund houses offer two broad types of options - Growth and dividend. There is always a debate that the growth option is better, or the dividend option is better. It is advised that you select the option that is more suited to your investment needs – financial objective and tax situation. Let us now discuss the difference between growth and dividend options and how they work.

Growth option: The profits booked by the investor in this scheme are getting reinvested back into the scheme. As a result of reinvestment of profits, net asset value (NAV) rises. It has been observed that as the scheme gains profit over time, NAV rises and in case of losses it falls. Investors can realize profits either by selling or redeeming the units. Growth options give returns in the form of rising values of mutual fund units. For example, suppose you buy 1000 units of an equity fund at a NAV of ₹ 30. When NAV rises to ₹ 40 in one year. Investors can sell the units and receive a sum of ₹ 40,000. Hence, profits from growth options would be ₹ 10,000 (₹ 40,000- ₹ 30,000). Given below are some of the key points to understand about growth option:

a) The NAV of the growth option will always be higher than that of the dividend option as the profits reinvested in the growth option may grow in value overtime.

b) Though the underlying portfolio of both dividend and growth options are the same, profits are reinvested in growth options and are distributed in the dividend option.

c) Usually the total returns of the growth option are higher than the dividend option over a longer investment horizon because of the power of compounding.

Dividend option: Under dividend option scheme, profits made by the investments will not be reinvested by the mutual funds. They are distributed as profits or dividends to investors on a daily, monthly, quarterly or annual basis. Distribution of dividends under mutual funds is completely at the discretion of fund manager. Dividend scheme of mutual funds comes in different forms such as dividend payouts and dividend reinvestment

Dividend payout plan: Under dividend payout plan investors get the dividend directly into their bank account.

Dividend reinvestment plan: Funds reinvests the dividend back into the same fund that has declared the dividend.

Given below are some of the key points to understand about dividend option:

a) There is no assurance about the dividend payout rate or timing of dividend payments.

b) As per SEBI guidelines, dividends must be paid from the accumulated profits of the scheme.

c) The dividend paid to the investors is adjusted from the Scheme NAV. For example, let us assume an Investor invests ₹ 10 in an equity fund. When NAV of the fund increases to say ₹ 15 and INR 3 is the dividend declared by the fund manager. New NAV after distribution of dividend will fall to ₹ 12. We observed from this example that as the mutual fund announces dividend, the NAV went down by the same amount.

Taxation

In the growth option, taxation is applied only at the time of redemption. Equity mutual funds that are held for less than 12 months, Short Term Capital Gains (STGC) are taxed at 15%. If the holding period is more than 12 months, Long Term Capital Gains (LTCG) of up to ₹ 1 Lakh are tax exempt for the financial year and thereafter, taxed at 10%. In debt mutual funds, STCG (held for less than 36 months) are taxed as per the investor’s income tax slab and the LTCG (held for more than 36 months) are taxed at 20% after allowing indexation benefits. 

In the dividend option, dividends paid by both the equity and debt mutual funds are taxed in the hands of the investors as per their applicable tax slab. As per Income Tax Act, if the investor is a Resident Individual and the dividend distributed or likely to be distributed the investor during the financial year exceeds ₹ 5,000 TDS @ 10% from dividend income is applicable. In case the investor does not have PAN, TDS rate of 20% is applied.

Mutual funds dividend versus Stock dividends

Mutual Fund and stock dividends are not the same. Stock dividends are distributed to shareholders when a company makes profits whereas mutual fund dividends may or may not be an indicator of the profitability of a mutual fund scheme. When investors get high mutual fund dividends then that does not necessarily mean that the fund is performing well and vice versa.

Growth or Dividend - which one is better?

Growth and dividend options give almost the same return. However, in case of dividend payout schemes, investors do not get the benefits of compounding returns as the dividend received is not re-invested. On the contrary, the growth option gives the benefit of compounding to the investors by reinvesting the profits which results in higher returns when the scheme matures. Investors who want to multiply their wealth in a longer period can choose growth options. Investors who have a specific financial goal to fulfill should also choose growth options. Investors who want regular income flow are suggested to invest in the dividend options.