Choosing between Growth and Dividend Option should be determined by the financial objectives of the investor. Investment horizon and tax considerations also determine, whether you should opt for growth or dividend options. Here are some general guidelines that will help investors choose between dividend and growth options:-
- If the investment objective is wealth creation, then the investor should choose the growth option. In growth option the profits remain invested and therefore the investor benefits from the compounding effect. The investment objective of an equity fund is primarily capital gains. Therefore equity fund investors should generally opt for growth option.
- If the investor wants some liquidity then he or she should opt for dividend option. However, it is important to note that a dividend option in an equity fund does not guarantee regular income.
- If an investor wants regular income then, he or she should opt for dividend option of an income fund or debt fund.
- Some investors want both liquidity in the form of regular income and capital gains. They have two options, depending on their financial requirements. If capital gain is the primary objective and liquidity the secondary objective, then such investors should opt for dividend yield equity funds. Such funds have a better dividend pay-out (please refer to our article, Top Mutual Fund Dividend Plans in the last 5 years) track record. If regular income is the primary objective and capital gains the secondary objective, then investors can opt for monthly income plans. Monthly income plans are primarily debt oriented income schemes, with a small equity component which helps in growing the capital of the investor.
- Liquid fund investors in the highest tax bracket, with an investment horizon of less than one year can get tax benefits by opting for dividend option. Short term capital gain is taxed at the tax rate of the investor. Dividends of liquid funds are tax free in the hands of the investor, but the fund has to pay dividend distribution tax at the rate of 28.3%. The dividend distribution tax is lower than the tax rate of the investor in the highest tax bracket.
- In the recent budget announcement, the minimum investment horizon for long term capital gains in debt funds has been increased to three years. If the investment horizon is less than three years then the capital gains will be taxed as per the investor’s tax bracket. Therefore, it may be beneficial for debt fund investors in the highest tax bracket with investment horizon of less than 3 years to choose the dividend option. However, as discussed earlier, choosing dividend option deprives the investor of the benefits of compounding. Therefore the investor should evaluate the trade-off between tax benefit and compounding of returns. If investors do not need the liquidity and just want to get the tax benefit, they should opt for dividend re-investment option. From an investment perspective dividend re-investment option is just like a growth option. On the other hand from a tax perspective dividend re-investment option is treated like a dividend option. Therefore by opting for dividend re-investment, investors can benefit both from the compounding effect as well as lower taxes.
- For equity funds both long term capital gains and dividends are tax free. Therefore, for investors with a horizon of more than one year tax should not be a consideration in choosing between growth and dividend option. While it is always prudent to have long time horizon while investing in equity, some equity fund investors invest in thematic funds for short term profits by taking advantage of specific market opportunities. While short term equity investments are speculative and risky, if the investment horizon is less than one year then dividend option is more beneficial from a tax perspective, because short term (less than 1 year) capital gain is taxed as per the tax rate of the investor, while dividends are tax free.