Understanding Growth and Dividend Mutual Funds
When you invest in a mutual fund, you normally have the choice of investing either in a growth plan or dividend plan of the same fund. You will also fund that the dividend plan normally tends to have a lower NAV as compared to the growth fund. The growth plan just accumulates your money while dividend plans tend to pay out regular dividends.
Can You Explain What Exactly is The Dividend Plan in a Mutual Fund?
If you opt for the dividend plan of a mutual fund, profits made by the mutual fund scheme are paid out to investors; either partially or in full. Normally, such dividends are declared at regular dividends. Generally, mutual funds pay-out dividends annually, although the dividend option of debt funds and shorter term debt funds even offer monthly or quarterly pay-outs of dividends to the investors.
The dividend option itself is further divided into two sub-options. There is a dividend pay-out option where the dividend is actually paid out to the investor in cash. The other is the dividend re-investment option, wherein the dividends are re-invested in the scheme.
Key highlights of the dividend pay-out plans of debt and equity mutual funds
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Dividends can only be paid out from the accumulated profits of the scheme, which is nothing but NAV accretion. Dividends cannot be paid out of capital
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Dividends cannot be assured. This applies to equity funds and even to debt and liquid funds. Neither the pay-out time nor the quantum can be assured by the fund.
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Very important to know that dividend paid is adjusted from the scheme NAV. Therefore, the NAV of the dividend plan sees drop in NAV to the extent of dividend paid.
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Dividends paid do not attract any withholding tax because dividends are fully taxable in the hands of the investor. However, effective the 2020 budget, there is mandatory deduction of TDS @ 10% from dividend income for Resident Individuals if the total dividend is more than Rs.5,000 for the full fiscal year.
What exactly do we understand by the growth option of mutual funds?
In growth option, profits made by the scheme are re-invested in the scheme, so nothing is paid out by way of dividends. Hence these schemes are also called auto compounders as there is automatic reinvestment of fund returns in the same fund. This helps to create wealth for the investors in the long run.
Since profits are reinvested, you also earn returns on returns apart from returns on principal. That is how the compounding works much more effectively in case of growth plans of funds.
Here are some important points you should know about growth option
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There is no difference in the portfolio of the growth and dividend plans. It is only the dividend pay-out model that changes. The dividend plan NAV is only reduced by the dividend pay-out and nothing else./p>
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It follows as a logical corollary that the Net Asset Value (NAV) of growth option will be higher than the dividend option because the profits re-invested in the growth option and nothing is paid out which reduces the NAV of the fund.
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The total returns of growth option are usually better than the dividend option over longer investment horizon as the compounding effect favours the growth plans while it works against the dividend plans.
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When you sell a growth plan mutual fund, it generates capital gains and not dividends. This is taxed as capital gains. Effectively, is no incidence of taxation in growth option unless you redeem the funds.
I am not clear why growth plans have a higher NAV?
The most basic argument against the dividend plan is that you just receive the dividend and use it for other purposes. You must actually reinvest the funds, but you rarely bother to reinvest the dividends. On the contrary, you are quite happy with the intermediate flow and want to use it for some pending purchase.
It is important to remember that when a fund declares dividend it is paid out of the NAV of the fund. That is your own money coming back to you. Therefore the NAV of the dividend plan will get reduced to the extent of the dividend. Let us understand how growth plans accumulate more value over time with a live example of both the plans.
| Dividend Plan | Amount | Growth Plan | Amount |
| Units Purchased | 10,000 units | Units Purchased | 10,000 units |
| Purchase NAV | Rs.12 per unit | Purchase NAV | Rs.12 per unit |
| Total Investment | Rs.1,20,000 | Total Investment | Rs.1,20,000 |
| NAV after 1 year | Rs.18 | NAV after 1 year | Rs.18 |
| Value after 1 year | Rs.1,80,000 | Value after 1 year | Rs.1,80,000 |
| Dividend Declared | Rs.4 | Dividend Declared | 0 |
| Dividend earned | Rs.40,000 | Dividend earned | 0 |
| Post dividend NAV | Rs.14 | Post dividend NAV | Rs.18 |
| Final Value | Rs.1,40,000 | Final Value | Rs.1,80,000 |
In terms of wealth effect both the dividend and growth plans are the same. The dividend plan has taken Rs.4 out as dividend and therefore its NAV is Rs.4 lower than the growth plan. The practical problem is that if this Rs.4 taken out as dividend is not reinvested then you lose out on wealth creation.
What is better for long term financial planning; Growth or Dividend Plans?
There are not 2 opinions, it has to be a growth plan. Your long term goals work on the principle of long term compounding and wealth creation. That is only possible through auto reinvestment which happens in a growth plan. When you are planning for long term goals like retirement or your child’s education; the power of compounding works in your favour.
But, that is only feasible if returns are constantly reinvested in the fund. If you opt for a dividend plan most of your returns get consumed as dividends and hence actual wealth creation will be lower. A growth option is like an auto compounder and hence more compatible with your long term life goals like retirement planning, child education, nest egg for the future etc.
Is it correct that growth plans are more tax efficient than dividend plans?
The problem with dividends is that is very inefficient in terms of tax. For example, if you get dividends on equity funds or on a debt fund, your tax rate applicable will be your peak incremental rate. If you are in the 30% bracket, that is the tax you pay on dividends. Plus you also lose because dividend is a post-tax appropriation.
With reference to capital gains, except for short term gains on debt, all the other methods of capital gains are more tax efficient than dividends. For example, in case of equity funds, short term capital gains are taxed at 15% and long term capital gains beyond Rs.1 lakh is taxed at 10%. In the case of debt funds held for more than 3 years, the LTCG is taxed at 20% after allowing indexation benefits. Either ways, growth plans are more tax efficient.
How do i manage regular expense flows with a growth plan?
That is one of the popular arguments given in case of dividend plans. If you opt for a growth plan, you do not get regular income. This is specifically true for retired persons who are relying on their debt fund portfolio to pay regular dividends. They need the money to meet routine expenses. However, there is another solution to this problem and it is called SWP.
You can structure a Systematic Withdrawal Plan (SWP) in a way that each month you withdraw part of the capital and a part of the returns. You only pay capital gains tax on the return portion and not on the principal portion. Hence a SWP model is more tax-efficient compared to a dividend plan and also gives regular income.
Generally, growth options are a better idea compounding logic and also more tax smart. Of course, in case you need regular income flows, you are better off structuring a SWP. You can have the cake and eat it too.