Save Smart . Choose growth over dividend plan in MFs

When you invest in a mutual fund scheme, you will, in most cases, be better off choosing its growth plan option over its dividend one. Here’s why.

Compounding effect

If your goal is to generate wealth for the long term, growth plans can help you do this far better than dividend plans. In growth plans, the gains made are re-invested into the scheme and so, your investment can potentially grow and compound automatically over the long term.

On the other hand, in dividend plans, the gains made by the scheme may be paid to you as dividends. So, the gains do not get re-invested into the scheme, and compounding does not happen automatically.

You can use the dividends received in any way — for expenditure or for re-investing in an instrument of your choice. Unless you re-invest, your wealth does not compound.

Note that in mutual fund schemes, dividends are paid only from the gains made on the investment; they are not an extra benefit given to investors. So, the net asset value (NAV) of the dividend plan unit falls to the extent of the dividend declared. For instance, if the NAV of a MF unit is ₹25 and it declares ₹3 as dividend, the NAV in the dividend plan falls to ₹22, while it remains ₹25 in the growth plan.

Tax efficiency

Even if your goal is regular income receipts from your mutual fund investments, dividend plans are not the way to go. One, they are not assured. A mutual fund scheme can declare dividends only from its distributable surplus, largely its realised gains. There may be times when a scheme is going through a rough patch and might not have enough to distribute as dividends. Even if times are good, the fund house is under no obligation to declare dividends; the decision is at its discretion.

Next, dividend payouts by mutual fund schemes fare poorly on the taxation test; and the investor bears the brunt. Dividends on equity-oriented mutual funds are subject to dividend distribution tax (DDT) of 10 per cent.

Add surcharge (12 per cent) and cess (4 per cent), and the effective rate of DDT is about 11.65 per cent. What this means is that if an equity fund scheme declares ₹100 as dividend, it has to pay a tax of ₹11.65 and give only the balance (₹88.35) to the investor. Now, while the investor gets only ₹88.35 as dividend in his/her hand, the NAV of his/her dividend plan falls by ₹100.

On non-equity-oriented mutual fund schemes such as debt schemes, the DDT is 25 per cent. Add surcharge (12 per cent) and cess (4 per cent), and the effective DDT rate is a mighty 29.12 per cent. So, out of the ₹100 declared as dividend by a non-equity scheme, it pays ₹29.12 as tax and only the balance (₹70.88) to the investor.

The NAV of the dividend plan though reduces by ₹100.

Now, compare this with the tax on gains from sale of mutual funds. In the case of equity mutual funds, gains on sale of units held for 12 months or less are considered short-term capital gains (STCG) — this is taxed at 15 per cent; including cess, the tax rate is 15.6 per cent.

Long-term capital gains (LTCG) on sale of equity funds (held for more than 12 months) are taxed at 10 per cent (10.4 per cent including cess). But LTCG of up to ₹1 lakh a year on listed equity and equity funds is exempt from tax.

The takeaway is that if you plan to hold your equity fund for 12 months or less, the dividend plan is better than the growth plan since dividends will be taxed at a lower rate (10.4 per cent) than the STCG (15.6 per cent). But if you plan to hold the equity fund for more than 12 months or longer periods — this is usually recommended — the growth plan will, in most cases, score over the dividend plan. Since LTCG of up to ₹1 lakh a year on equity funds is exempt from tax, the tax outgo will be lower. Also, if you can calibrate your redemptions and restrict the LTCG in a year to ₹1 lakh, you can avoid the tax completely.

On non-equity mutual funds, gains on sale of units held for 36 months or less are considered short-term capital gains (STCG) — this is taxed at the investor’s slab rate (5, 20 or 30 per cent, plus cess). LTCG on sale of such funds (held for more than 36 months) are taxed at 20 per cent (20.8 per cent including cess) after indexation benefit. Indexation means increasing the cost of acquisition of the investment to account for inflation; this effectively reduces the LTCG amount and lowers the tax.

The takeaway here is that growth plans invariably score over dividend plans in non-equity funds. That’s because on STCG in non-equity funds, the tax rate for most investors (5.2 per cent or 20.8 per cent) is lower than the DDT (29.12 per cent). For investors in the highest tax slab (31.2 per cent) looking to sell within 36 months or less, dividend plans may be somewhat better, but the difference between the tax rates is not much. For those who will be holding non-equity funds for more than 36 months, the growth plan is a clear winner since the tax rate on LTCG (20.8 per cent after indexation) is lower than the DDT (29.12 per cent).

It is also to be noted that in both equity and non-equity plans, the entire amount of dividends are taxed, while only the gain portion on sale of investments is taxed.

If you seek regular incomes from your mutual funds, it is better to go for the systematic withdrawal plan (SWP) option — after 12 months in equity funds and after 36 months in non-equity funds to qualify the gains as LTCG. This will optimise your tax outgo and give you certainty of cash flows.

COMMENT NOW