Growth option vs dividend plan in mutual funds: Which one should you opt for?

When you invest in a mutual fund, your fund typically offers you a choice of two plans: Growth Plan and the Dividend Plan. There is a dividend reinvestment plan, which is not often used and hence we shall not dwell on the same. We shall look at a growth plan and a dividend payout plan. Essentially, the difference is quite simple. In a growth plan, the fund does not payout anything to the investors by way of regular payouts. All the profits of the fund are reinvested in the fund and therefore your wealth compounds. On the other hand, the dividend plan pays dividends out of profits earned and income generated. Remember, a fund is not permitted to pay dividend out of capital. The big question is how to choose between a growth plan and dividend plan. Firstly, let us look at what these plans are all about.

Comparing a dividend plan and a growth plan

The difference between a growth plan and dividend plan can be best understood with the help of an example.

If you look at the above instance, you will see that the wealth effect is the same in case of the growth fund and the dividend fund. The Growth plan, when sold in May 2018 gives Long Term Capital Gains of Rs 27, whereas the Dividend plan gives a capital gain of Rs.21 but it has already paid out Rs.6 as dividends to the mutual fund investor. So, the wealth effect is the same in both the cases. Then what are the criteria to choose between a growth plan and a dividend plan? There are three points on which the choice between dividend plan and growth plan has to be made.

How do the tax implications of a growth plan and dividend plan compare?

That is an important aspect of the choice between growth plans and dividend plans. For example, when the mutual fund pays out dividends, it is tax free in the hands of the investors. However, the fund will deduct Dividend Distribution Tax (DDT) at the rate of 10% from the dividends distributed and only pay out the net amount to the unit holder. In case of growth plans it is classified as STCG if held for less than 1 year and taxed at 15%. For an investment of less than 1 year, the dividend plan does appear to be more useful. But, in case the fund is held for longer than 1 year then it becomes LTCG and is taxed at 10% only if the gains are above Rs.1 lakh. For small and medium sized investors the annual dividends may not cross the Rs.1 lakh mark and hence the growth plan may be more efficient in tax terms. Even for larger investors, the growth plan will be relatively more efficient.

What fits better in your long term financial plan?

This is one area where the growth plan really scores over the dividend plan. When you opt for a dividend plan, the fund regularly pays out dividends out profits and to that extent your NAV reduces. But do you reinvest these dividends? More often than not, investors use the dividends for other purposes and to that extent your wealth diminishes. Growth plans on the other hand are auto compounders. Since the profits are automatically reinvested by the fund, the growth plan is more in sync with long term wealth creation. The power of compounding works best in case of growth plans. Also, when you make a financial plan you peg your SIPs to specific goals. A growth plan ensures that you can estimate returns more credibly and hence long term wealth creation becomes more predictable. In case of growth plans, it is always more in sync with financial planning.

What if you are retired and looking for regular income?

This is one case where you actually require regular income. So can such persons opt for a dividend plan? There is a catch here. When you are retired and looking for regular income, then your risk appetite is low and hence you prefer to invest in debt funds or liquid funds. The DDT is much higher in these cases because in case of debt funds and liquid funds the dividend distribution tax is charged at the rate of 29.12% (25% tax + 12% surcharge + 4% cess). A better way would be to structure the payout in the form of a Systematic Withdrawal Plan (SWP) so that you are only taxed on the capital gains component and not on the principal component. That would work better than a dividend plan. The bottom-line is that growth plans are more efficient from the point of view of taxation as well as from the point of view of long term financial planning. The choice is quite clear!

Sandeep Bhardwaj is Assistant Director and Chief Sales Officer at Angel Broking