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Dividend Option vs Growth Option in Mutual Funds

February 12 , 2013

A lot of mutual fund investors are confused with growth option and dividend option. It is very imperative to understand its implication on your personal finance. Selecting the right option is as important as selecting the mutual itself.

Why does a mutual fund scheme have different options?
You may have noticed a same mutual fund scheme having two options; growth and dividend option. Their NAVs are different and in most cases NAVs of dividend options are much lower than the growth option. So does it mean they are two different schemes? No, the scheme invests in the same set of stocks or bonds but the nature of distribution of profit differs.

The behavior, objective, fund manager, performance are all the same but only the way your returns are delivered is different. Then you may ask, what is the big deal about these options? Let us understand them in detail.

Growth Option
Under growth option, you do not receive any returns in the intermediate. You do not get payments in the form of interest, dividends, gains, bonus etc. You get your returns only on selling the units. The returns will be the difference in selling price and purchase price, similar to gold investment. The NAV on the date of investment will be the cost price and the NAV of the sale date becomes the selling price. The difference is your return. For example if you had bought 100 units of a mutual fund scheme at an NAV of Rs 50 and sold those units after 6 years when the NAV was reached Rs 120, your returns would have been Rs 7000. You would not have got get any payout in between.

Dividend option
Under dividend option, you receive returns at periodic intervals. However, the intervals are not certain and dividend amount is also not fixed. Under dividend option, the NAV is not let to grow higher and whenever it reaches a certain level, the fund house pays out dividends. Assume you have invested in a fund at the NAV of Rs 14 and opted for dividend option. The scheme performs and NAV reaches a level of Rs 16. The fund house may decide to pay out Rs 1.50 as dividend. So you receive Rs 1.50 and simultaneously the NAV will fall back to Rs 14.50.

Should I choose growth option or dividend option?
This is quite straightforward. You may have to take 2 things into consideration while you decide- the objective of your investment and income tax. For equity mutual funds, the best bet would be growth option. This is because you can make compounding work for you. If you receive regular dividends, you may end up using that money for non-priority things. Wealth per se is created only if you let it compound. Suppose one instrument is giving 15% returns per annum, the other is giving 13% per annum. If you choose the latter one but it is left to compound then it will create far more wealth than the former one giving 15% returns. That is why Gold or Real Estate is perceived to be big wealth creators.

When you choose growth option the returns in tax parlance is called as Capital Gains. The good news is that capital gains in growth option of equity mutual funds are non-taxable. But in case you sell the units within one year you are liable to pay short-term capital gains tax. This does not matter since investment in equity mutual funds should always be only for long-term.

Now if you are planning for investing on short-term basis, debt mutual funds will suit the best. For short-term (less than a year) investments in debt funds, we recommend you to go to dividend option or dividend re-investment option, primarily on tax considerations. Though dividends are tax free at the hands of investors, the fund has to pay tax (dividend distribution tax) of 12.5% before it pays you. In case you go for growth option the returns will be considered as short term capital gains, for which you may have to pay at the marginal tax rate (as per your tax slab). So if your come under 30% tax bracket then you will end up paying lesser rate if you choose dividend option in debt mutual funds.

For mid-term (more than 1 year) investments in debt mutual funds, you may opt for growth option, as the capital gains tax in that case will be 10% without indexation or 20% with indexation, which is more likely to be less than your marginal tax rate.

Summary
For long-term needs (5 yrs or more): equity mutual funds with growth option
For short-term needs (1 month to 2 yrs): Debt mutual funds with dividend option or dividend re-investment option
For mid-term needs (3 to 5 yrs): Balanced mutual funds with growth option

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