The idea of a dividend represents a reward or additional money in popular perception and many investors opt for dividend options of mutual funds without realizing that dividends erode wealth in almost all cases.
Dividend in Equity funds vs Debt Funds
When investing in Equity funds, your main objective should be to grow your wealth over the long term. Receiving dividends is therefore, pointless as it shifts money to cash instead of allowing it to grow.
In debt funds, where an investor is seeking a cash flow, it is better to withdraw when you need rather than opt for a dividend plan.
A dividend is an optical illusion
To understand how dividend in debt mutual funds works, let us take an example.
Let’s say you’ve invested Rs 100 in a debt mutual fund. Over time the value of the mutual fund grows and your Rs 100 become Rs 110. At this time, the fund manager decides to distribute Rs 5 as dividend. They send you a cheque for Rs 5 and the value of your mutual fund becomes Rs 103 after the fund pays approximately Rs 2 as tax (@28.84%) on the dividend paid to you.
So you as an investor now have Rs 103 in the mutual fund and Rs 5 as cash. Your Rs 110 have become Rs 108.
Most investors remain unaware of the fall in their mutual fund value because of this tax payment. This is the reason, dividend options continue to be popular.
But isn’t a dividend paying fund a better performing fund?
The fact that you got a cheque for Rs 5 does not in any way reflect the performance of the fund. The fund manager could have sent you Rs 5 even if they made only Rs 6, 7, or 8. The real performance of the fund is measured by how much your Rs 100 became before the dividend was paid out.
So please ignore the advertisements that seem to imply that a dividend pay out implies fantastic performance.
What if you need regular income?
Invest in the growth option and simply withdraw from your debt fund only the amount you need, when you need it.
Depending on your tax bracket, you may have to pay tax on some of the amount you withdraw. In the above example if you withdraw Rs 5, you pay income tax on approx 50 paise, This tax would be 10 paise if you are in the 20% tax bracket.
So you will get Rs 4.90 in hand and still have Rs 105 invested in the mutual fund. A total of Rs 109.9 in this approach instead of Rs 108 in the dividend option
Please note that as your investment gets older, this tax amount drops to almost nil due to indexation. (More on this topic here).
Then, why does the dividend option exist?
There was a time, when there was no tax on dividend distribution and dividend option provided a tax efficiency. This tax break was eliminated a few years ago.
Note: For individuals in the highest tax bracket, a dividend option in debt funds still provides a miniscule tax advantage, but you have to be investing really large amounts to make that meaningful. People who invest such large amounts are unlikely to be reading this article.