“Should I go for growth option or take out the dividends in my fund?” - is a question frequently asked by many of you, when venturing into mutual fund investments. We have already discussed how dividends are paid out and how your NAV reacts in our last week’s article - What are dividend and growth options
We also summarized what to choose. This week, we elaborate on which option to go for, based on your cash flow need.
Which one to choose?
Two key factors will determine what is appropriate option is for you:
- Cash requirement and time frame
- Tax efficiency
Most people base their decisions on tax efficiency. While it is a key deciding criteria, let us also look at how other factors too will play a role in choosing between dividend and growth.
Equity funds
Let’s take on the easy one first. Equity funds are meant for the long term. Your reason for choosing an equity fund must be to build wealth towards some goal which is perhaps at least few years away.
That simply means you should stay invested in the fund and not take the cash out (unless you will invest the dividends back diligently)to help compounding work for you. Since, long-term capital gains are free of tax, the solution here is simple: As a general principle, go for growth or dividend reinvestment in equity funds.
But there are exceptions: One, in case of theme funds or sector funds that you hold tactically, you may wish to either opt for dividend payouts or book profits as the fortunes of themes can take a turn after one good cycle. Two, in case of ELSS, given that your money is locked in, you may wish to go for a dividend payout if you are in say your 50s and are a bit averse to risk and wash some profits in cash during the lock-in.
Young investors should allow their tax saving fund to grow with growth option.
Debt funds
This category gets a bit tricky because the dividend suffers dividend distribution tax (DDT).DDT is nothing but the tax on your dividend. While it is not deducted on your dividend directly in your hands, it is reduced from your NAV.
Given this tax component, dividend payout and dividend reinvestment can be tax inefficient. Let us look at whether you need to opt for it.
- You need some cash flows from your debt fund:In this case, you can choose the dividend payout or the systematic withdrawal plan (SWP) under growth option. Look at the table below. The SWP is a clear winner for those in the 10% and 20% tax brackets. But please ensure that you do not end up paying exit load. Opt for SWP post the exit load period if you wish to avoid the load.
Those in the 30% tax bracket, can go for dividend payout, if you intend to hold the fund for less than three years. But if you are invested for more than 3 years and redeem post that then growth option makes sense, since you will get capital gains indexation benefit. In such a case go for SWP for regular cash flows. Each such redemption will get capital gain indexation benefit if your investment is over 3 years old.
Remember, switching between options will also unnecessarily entail capital gains tax if you have profits. Hence, get your investment time frame right when you start your investment.
- You don’t need cash flows from your debt fund: In this case, dividend payout and SWP are not needed since you have no cash flow need.
You therefore have 2 options – to go for growth or dividend reinvestment. Look at the table below - growth option scores in most cases, except when you are in the 30% tax bracket and redeem in less than 3 years.
This will be true in case of liquid funds or ultra-short-term funds that you may park for a short while. In that case you will suffer DDT of 28.33% (including surcharge and cess) on the dividend reinvested. This will be slightly lower than the income tax slab of 30.9% (including cess).
Consider your fresh investments through the above routes. But if you make your switches now,do take into account the exit load and the capital gains, (will vary for each fund) if any,you may suffer on the fund now.
