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Mutual funds:Should you go for dividend or growth?

Last updated on: July 30, 2012 18:36 IST

Mutual funds:Should you go for dividend or growth?

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Ramya Ramachandran, InvestmentYogi.com

The most common dilemma faced by many mutual fund investors is choosing between the growth, dividend payout and dividend reinvestment option. Distinctly different in nature, all the three options come with an earning potential. Deciding on which one to choose greatly depends on your individual financial needs.
 
Here is a brief on the factors that govern these options and useful tips to help you pick the most suitable option.
 
Introducing the options

Whether you choose the growth, dividend payout or dividend reinvestment option, none of the options really bring in significant losses. The difference primarily lies in the way these options function.
 
Growth option

In this option any profits declared by the company is ploughed back into the scheme. Works very similar to your bank fixed deposit where the interest is put back into the fixed deposit, the growth option compounds your earnings over time. Redeeming your units will help you realise the growth the scheme has generated.

Dividend payout

In the dividend payout option, any profits declared by the scheme are distributed or paid out to the investors at periodic intervals (monthly, quarterly or yearly).

Dividend reinvestment

This option is a variant of dividend payout. Instead of the profits being paid out, the declared dividends are used to purchase additional units at the prevailing NAV.
 
Remember, dividends are not guaranteed and are declared entirely at the discretion of the mutual fund company.
 


Investmentyogi.com is a one-stop personal finance website which helps in managing finances, investments and taxes through services like financial planning, online tax filing, budgeting and 'Ask the Expert'.


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Implication on the net asset value

The net asset value (or NAV) of the scheme has a direct bearing on the option that you choose.

NAV of growth option

With profits being ploughed back into the scheme, the NAV of a scheme under growth option increases when profits are declared. So if over time, the scheme is generating significant profits, it is pulled back into the scheme, pushing the NAV up, thus compounding your principal.

NAV of dividend payouts

The regular dividends that are declared in this option is paid out from the NAV of the unit. Thus, when a dividend is paid out, you could expect the NAV of the scheme to go down by an equal amount.

For example, suppose the NAV of the scheme is Rs 58 and a dividend of Rs 5 is declared and paid put. The NAV would correspondingly go down by Rs 5 to Rs 53. It is because of this reason the NAV of a dividend scheme is lesser that the NAV of a growth scheme.

NAV of dividend reinvestment

Even though the dividend is used to purchase additional units, NAV of the scheme will fall subsequent to it being declared. So whether the declared dividend is paid out or reinvested, you would experience a fall in NAV. It is for this reason the NAV of a dividend payout and dividend reinvestment scheme is always the same.


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The tax angle

The tax angle of the three options depends on the type of scheme -- whether it is a debt or equity oriented scheme, and on the holding period -- whether long term or short term. Dividends of mutual funds of both equity and debt funds are tax free in the hands of the investor. However debt funds attract a dividend distribution tax of 12.5 per cent. This DDT is borne by the investor, as a cut from the NAV.

Equity funds attract only short term capital gain tax and, do not have long-term capital gains tax. Debt funds on the other hand, attract both long term and short term capital gain tax.

Growth option

Growth options do not attract dividend distribution tax.

Dividend payout and reinvestment option

The dividend declared by mutual funds would be tax-free in the hands of the unit holders. Investors would, however have to bear dividend distribution tax.


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Making the choice

When making a choice you would have to consider their individual needs and goals. If regular income is what you are looking at dividend payout could be the right choice. You could also reinvest these declared dividends in other avenues effectively to earn superior returns.

If you are risk averse and wish to book market profits regularly, a dividend payout helps, as even if the market goes down, you would have already booked your profits.
 
If capital appreciation is what you seek and you have a long term investment horizon, then opt for the growth option. A dividend reinvestment could also be considered if you are looking at long term capital appreciation. A reinvestment option, gives capital appreciation in the form of increased unit in the scheme.


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