Mutual fund investments come with multiple options to suit your money management needs. One of them is the choice to invest either in the growth or dividend option of the scheme.
The difference in the two is that the growth option does not make any interim payouts to you; profits or gains that accumulate in the fund are reinvested automatically in the fund and reflected as gains in the daily net asset value (NAV) or price of the scheme.
Whereas, in the dividend option, interim profits and gains are given out to investors on a regular basis. This time frame may be pre-defined or random.
Usually, dividend options work if you are looking to get some regular income from your mutual fund investment. Recent changes in dividend taxation are an incentive to ignore that choice and stick to the growth option.
Till the previous financial year dividend paid out by a mutual fund scheme was tax-free in the hands of the investor. Mutual fund schemes used to pay a dividend distribution tax (DDT) which was adjusted against the final payout made to investors. For equity mutual funds, this was at 11.64% and 29% for debt mutual funds.
Post Budget 2020, dividends are now taxable when you receive them. For those in the highest tax bracket, this means you will have to pay tax of anywhere between 35% to 42% on the dividend income you receive from mutual fund schemes.
Compared to this, the tax applicable on gains accrued from growth option is lower. Although for debt mutual fund schemes, short term capital gains in the growth option are taxed at income tax rate, long term capital gains (if you hold for at least 3 years) are taxed at 20% on indexed cost, which, lowers the tax outgo considerably.
In case of equity funds, gains from growth option are taxed at 15% for short term capital gains and 10% for long term capital gains on schemes held for at least one year.
Is switching to growth an option?
If you are already invested in dividend options, unaware of this change and think that it makes more sense to be in the growth option of the same scheme, you will have to fill an application for switch from dividend plan to growth plan. While the scheme remains the same, the NAV of both plans is different.
The switch is possible but keep in mind that if you are a long-time investor in a particular scheme, you will end up paying capital gains tax on any accumulated gains at the time of the switch. A switch is as good as selling out of one scheme and buying a new one. If you are a fairly recent investor, while you may not have to contend with high capital gains tax, you should look out for exit load cost on redemption of the scheme.
Going forward, it’s in your best interest to stick to the growth option in case of mutual fund schemes, be it debt or equity. It will be a lot more tax efficient in the long run, plus it’s an incentive not to have pay outs in between so that the fund value can accumulate better over time.