Any mutual fund scheme offers investors two choices, to invest in the growth option or the dividend option. The growth option adds back any profits made from selling securities in the portfolio to your unit value or net asset value per unit. On the other hand, the dividend option accumulates the profits and then pays them out to you after a few months on an assigned date.
In both cases you will make the same return, however, in case of a dividend option you have the profits in your hand and in the growth option they get added back and reinvested.
This distinction may not seem material enough at first glance, but dig a little deeper and you will see there are two clear reasons to avoid taking the dividend option.
1. Dividend distribution tax
Debt funds carry a 25% dividend distribution tax and in Budget 2018, a 10% dividend distribution tax was introduced for equity mutual schemes. This tax is not seen by the investor; however, the asset manager must deduct this amount of tax before distributing the surplus to investors as dividend.
The tax rate carries 12% surcharge and 4% cess, making it an even higher deduction. Hence, even though dividend is not taxable once you receive it, some tax has already been deducted before disbursal.
For those who were choosing the dividend option in debt funds and are subject to the 10% or 20% income tax rate, it is now more suitable for them to pick the growth option and pay short term capital gains tax if they redeem before three years or long-term capital gains tax with indexation on redeeming after three years.
Equity mutual fund investors ideally, should not redeem before at least 3-5 years; long term capital gains tax for equity mutual funds is at 10% too, making the net returns from dividend and growth options similar.
2. Dividend taken now, is wasting your future profit
For equity mutual fund investors, as mentioned above, the first rule is to remain invested for longer periods. Hence, by picking the dividend option you are eating into the profits which could otherwise have been reinvested for future growth.
Moreover, unlike dividends paid by corporates as a means of sharing profits otherwise inaccessible to investors, mutual fund dividend is not an additional income. It is drawn from gains accrued on your existing units and paid to you sort of in advance.
As a result, after the dividend is paid the price of your units will fall by a proportionate amount. This dividend in your hands is likely to get spent, never giving you the chance to realise the long-term potential growth from an equity investment.
In mutual fund investing, dividend option is simply not an efficient way to build your corpus. Stick to growth options across schemes and realise better growth.