June 07 , 2012
In a dividend option fund, the rise in value of the fund's investments (if any) are removed from the fund and assigned for payment to the investor. In the reinvestment option, they are immediately ploughed back into the fund (as against payout option, where they are paid out to you). In some funds, you can choose how often this is done.
Why would you want to have a dividend, and plough it back immediately? Because, in some cases, notably debt funds, dividends enjoy a more lenient capital gains tax rate than short term capital gains. So, instead of letting the funds stay and the NAV rise, you opt to get a dividend and plough it back. In the process, you only incur the lower dividend distribution tax.
For equity investments, there is no sense in going for this option at all! For debt investments, if you plan to keep the money invested for less than a year, you should choose this option rather than any other.