What is a Dividend Reinvestment Plan?
A dividend reinvestment plan allows you to reinvest the money you earn through dividends in the mutual fund itself. Through this plan you will receive additional units as dividends, and over time, you can accumulate more units of the mutual fund scheme. Thus, if you’re a long-term investor, a dividend reinvestment plan may help you benefit from compounding with time.
However, even though you are reinvesting your dividends, they are still subject to taxation.
In India, institutional investors such as banks, financial organisations, and insurance firms participate in dividend reinvestment plans. Individuals can also obtain similar advantages by investing in dividend reinvestment plans offered by mutual fund houses. But, not all dividend paying mutual funds provide a Dividend Reinvestment Plan.
How do Dividend Reinvestment Plans Work?
Before understanding how the plan works, let’s look at the different investment options available:
There is no dividend payout in the growth strategy of a mutual fund. The value of a growth plan increases over time since all earnings generated by the portfolio are reinvested in the programme.
Dividend Payout Plan
Out of its profits, the fund declares dividends in a dividend payout plan. The dividends paid to the investors cause a decrease in the NAV of the dividend plan. A dividend payout plan’s NAV will be lower than a growth plan’s NAV.
Dividend Reinvestment Plan
Dividends that would have otherwise been distributed to fund investors are instead utilised to buy more units of the fund. When dividends are paid on the units in the fund, no cash is sent to the investor.
Instead, the fund’s administrators automatically utilise funds to purchase additional fund units on behalf of the investors and deposit them to each investor’s account.
Let’s understand with the help of an example, how the 3 mentioned plans are different from each other.
|Growth Plan||Dividend Payout Plan||Dividend Reinvestment Plan|
|Original Units Purchased as of June 1st 2021||1,500||1,500||1,500|
|NAV (in INR)||20||20||20|
|Value of Investment (in INR)||30,000||30,000||30,000|
|Dividend Declared (On Oct 1st 2021)||No dividend distributed||5||5|
|NAV (before dividend distribution)||25||25||25|
|NAV (post dividend)||25||20||20|
|Dividend Reinvestment Amount (Dividend – 10% TDS)||NA||6,750 = (7,500 – 10% of 7,500)||6,750 = (7,500 – 10% of 7,500)|
|Extra units acquired||None||None, dividend paid in cash.||337.5(1,500 units * 5 dividend per unit = 500)Now, dividend payable / NAV post dividend6,750 / 20 = 337.5|
|No. of Units (post dividend)||1,500||1,500||1,837.5(Original number of units + Extra units acquired)|
|Value of Investment Post Dividend||37,500||30,000||36,750|
|Tax On Dividend If You Fall Under 30% Tax Slab||NIL||30%*7,500 = 2,250||30%*7,500 = 2,250|
|Post-Tax Total Investment Value||37,500||28,500 (30,000 – (2,250 – TDS 750))||35,250 (36,750 – (2,250 – TDS 750))|
Who Should Opt for Dividend Reinvestment Plans?
Dividend reinvestment plans reinvest the dividend distributed by the mutual fund. As a result, investors receive additional units of the fund.
However, long-term growth plans are ideal for investors as the capital appreciation is greater than dividend reinvestment plans. Though you may receive additional fund units in the dividend reinvestment plan, the capital appreciation may be lower (as the NAV falls to the tune of the dividend announced), and the dividend is taxable as per your income tax slab rate.
Things to Remember Before Investing in Dividend Reinvestment Plans
Investors should consider the following things before investing in DRIPs:
- Financial awareness: One should be well aware of their financial needs and investment objectives before investing in a dividend reinvestment plan.
- Taxation: They are now taxable according to the tax bracket of the investors.
- Liquidity and periodic dividends: With liquid funds, where dividends are declared daily or weekly, these plans perform well.
- Lack of options: Only a few mutual funds in India offer the option of automatic dividend reinvestment.
Advantages and Disadvantages of Investing in a Dividend Reinvestment Plan
Following are the advantages of DRIPs:
- Averaging your entire investment cost, you receive more units when the fund’s NAV is low. If the NAV per unit dramatically increases by the time of your exit, this may help you accumulate a substantial corpus.
- You can benefit from the compounding gains over time when you acquire more fund units that could also generate returns for you.
- Automated investment processes. Some mutual fund schemes provide dividend reinvestment plans. Thus saving you from all the hassle of researching where to invest the dividends. Additionally, your investment does compound with time.
- A safeguard against market volatility. Using DRIPs you invest in the market regularly.
The following are the disadvantages of DRIPs:
- Typically, DRIPs are long-term investments. DRIPs are not suitable for investors whose primary source of income is dividend cash payouts.
- Furthermore, DRIPs might disrupt the balance of your portfolio if you keep investing in the same mutual fund scheme.
- Whenever a dividend is announced, whether it be a dividend distribution or dividend reinvestment, the mutual fund’s NAV declines. As a result, you will have to wait a long time before the NAV significantly rises in order to enjoy a significant return on your investments.