Mutual Funds: Why Growth Plans Are A Better Option For Investors

While making some investments under the mutual fund scheme, Ashok opts for the dividend scheme. He believes that if he opts for a growth plan, he may not get the periodic payments he would prefer to manage his money requirements.

It is also preferable to select MF charts that announce periodic earnings. Mentally, equate a dividend plan with fixed deposit plans of banks where interest is paid periodically. Is this the right approach? What should be the basis for choosing a dividend plan or a growth plan?

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In general, microfinance distributors encourage growth schemes “if one does not need regular cash inflows”. Even some finance houses suggest this. But this may not be the right approach.

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Growth versus dividend option

In a growth option, the profits made by the plan are reinvested in the scheme rather than being paid out to the investors. Since the profits are reinvested in the scheme, the investor can profit from the profits and thus benefit from the compounding. Under a dividend option, profits reserved by the fund manager are distributed to the investor.

Dividend distribution by MF is not the same as dividend distribution by a corporation (to its shareholders). Dividend distribution by a company is from the profit it makes. It indicates the company’s profitability and also the extent to which it is distributed from its profits.

When the MF pays a dividend, the NAV of the fund correspondingly decreases, and thus the investor’s outstanding investment also decreases.

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Instead of opting for a dividend plan, one can opt for a growth plan and use the redemption facility for any periodic requirements. There are even systematic withdrawal plans available.

Taxes are different

Taxes on dividends and redemptions are different. After the abolition of the dividend tax in 2020, all dividend income is subject to taxation according to the income tax bracket under the heading, “Income from Other Sources.”

TDS (Tax Deducted at Source) also applies to dividends distributed by MF scheme. Under the new rules, when an MF distributes dividends to its investors, it must deduct 10 per cent of the total taxes payable under section 194k if the total dividends paid to the investor exceeds INR 5,000 during a financial year. This can be claimed when filing the tax return.

To recover, there is a capital gains tax. This depends on the type of MF as well as the duration of the investment. For equity funds, the short-term capital gains (STCG) holding period is less than 12 months and for debt funds, it is less than 36 months. After this period, it is treated as long-term capital gains (LTCG).

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The Saudi Telecom Company (STCG) on the sale of units of equity-oriented microfinance schemes is charged at 15 per cent. In debt schemes, it is charged according to the resident’s tax bracket.

LTCG is taxed on MFs (equity-oriented schemes) at the rate of 10 per cent on capital gains above ₹1 lakh. In debt-oriented schemes, it is charged at 20 per cent with indexation interest.

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Obviously, one can save tax by opting for the growth scheme and using the recovery facility instead of opting for the dividend scheme. In a dividend scheme, the entire dividend receipt is subject to tax, apart from the withholding tax provision, while capital gains tax may be favourable.

Moreover, the individual investor can exercise the redemption independently, while the profits are determined by the mutual fund.

the exception

Equity-linked savings programs come with a three-year lock-in period. Therefore, units cannot be exchanged during that period. If one opts for the dividend plan in this case, and if the fund also announces dividends during the holding period, it can be beneficial for the investor as it increases cash flow. In all other cases, there is no need to choose a dividend plan.

(Writer retired banker The opinions expressed here are those of the author and do not constitute investment advice.)

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