Generally, when individuals venture out to invest in mutual funds, they face two primary options: growth funds and dividend funds.
Curiously, while both investment options have the same underlying portfolio, they trade at different net asset values (NAVs) and even face different tax implications. Why is this the case, and what are the other parameters on which dividend funds differ from growth funds? Let’s find out.
What is Dividend Mutual Fund?
Before we delve into dividend funds, let’s first understand what dividend in mutual funds is. A dividend in a mutual fund scheme refers to NAV accretion. In other words, the fund’s manager decides what part of the profit will be distributed to the unit holders as a dividend. Unlike stock dividends, dividends in mutual funds are not an indication of the fund’s profitability. This means a higher dividend payout doesn’t translate to higher scheme profitability.
Thus, a dividend mutual fund is one that distributes dividends to its unitholders at some interval—monthly, quarterly, or annually. However, these dividends are not assured, and can only be paid out of accumulated profits.
To avoid any confusion, SEBI, in 2021, has mandated all fund houses to change the names of their dividend option schemes to ‘Income Distribution cum Capital Withdrawal’ (IDCW) plans. These schemes include both the dividends paid by stocks as well as the capital gains received on the sale of underlying stocks as distributional profits.
When dividend funds distribute dividends, their NAV values are reduced. For instance, if a fund’s NAV is trading at Rs. 15, and a dividend of Rs. 4 is distributed, then the NAV value will be reduced to Rs. 11 (Rs. 15 – Rs. 4).
However, some schemes also offer the option to reinvest these dividends. In the dividend-reinvestment option, the NAV will not trade ex-dividend, instead, the units held will increase. Another option is dividend-sweep, which invests these dividends in another mutual fund’s scheme of the same AMC.
What is Growth Mutual Fund?
A growth mutual fund reinvests the profits earned, rather than distributing them to its unitholders. As a result, the NAV for growth funds is higher than the NAV for dividend funds. Additionally, these auto-compounder schemes create higher wealth for their investors in the long run.
By reinvesting all the profits, a growth-type mutual fund manager can improve the scheme’s NAV. Investors can, then, make a profit by selling their units or at the time of redemption. To illustrate, consider a scenario where you buy 100 units at Rs. 40, and their NAV rises to Rs. 50 after a year due to reinvestment. On selling these units, you can make a profit of Rs. 1,000.
A growth mutual fund is more suitable for investors who are high-risk takers and do not require regular income. Young investors with long horizons, or couples with young children planning for college expenses, should consider investing in growth funds. These funds are also optimum for those falling under lower tax brackets of under 10%, as they wouldn’t be levied any dividend distribution taxes.
Dividend Funds vs Growth Funds: Which is better?
Now that we understand the concept behind both mutual fund options, let’s compare the two to demystify the mutual fund growth vs dividend debate.
|Distributes profits on a regular schedule to the unitholders
|Reinvests all profits earned. Unitholders can book a profit either by selling the units or at the time of final redemption.
|Since dividends are paid out of accumulated profits, the NAV of dividend funds will be lower (by the amount of distribution) compared to growth funds.
|Higher NAV values as profits are reinvested and not distributed.
|Dividend funds lose out on the compounding effect on the dividends distributed, thus resulting in relatively lower total returns.
|Growth funds earn higher total returns as the profits reinvested grow in value over time.
|Lower risk, as investors get regular cash payments in the form of dividends.
|Higher risk, as unitholders need to stay invested for a longer duration to benefit from price appreciation and compounding
|Dividends are added to the total gross income and are taxed as per the applicable income tax slab. A TDS is also deducted if the total dividend amount exceeds Rs. 5,000. Additionally, the AMC is mandated to charge a 10% dividend distribution tax at the fund level before distributing dividends.
|No taxation till redemption. At maturity, short-term/long-term capital gain rates will apply depending on the holding period*.
|Ideal for investors requiring regular, steady cash flows
|Ideal for individuals investing in long-term wealth creation
*For equity funds held under 12 months, an STCG of 15% will be applicable, while for the remaining funds, an LTCG of 10% will be applicable after exempting the initial capital gains of up to Rs. 1 lakh. For debt funds held for less than 3 years, the STCG rate will be in line with the income tax slab of the investor. However, for debt funds held beyond 3 years, an LTCG of 20% will be chargeable after factoring in indexation benefits.
Which Option is Better for You?
The ultimate decision should be determined based on your investment goals and tax implications. While a growth plan will provide higher returns for its investors, it does not yield any regular income. Thus, a dividend fund will be more suitable for those requiring regular income, such as senior citizens, or the ones with unstable income streams.
In contrast, growth funds are ideal for those interested in wealth generation and have long time horizons. Besides, growth funds beat out dividend funds in terms of taxation. This criterion will be immaterial if the total dividend earned does not exceed Rs. 5,000 in any financial year, or if your total income does not exceed Rs. 5 lakhs, thereby making you eligible for a rebate under section 87A of the IT act on the dividends earned.
Individuals can additionally explore the option of investing through a Systematic Withdrawal Plan (SWP) if they want a more tax-efficient method of earning a steady income. Here, you only pay taxes on the excess return and not on the principal amount.
Why a Growth Mutual Fund?
A Growth Mutual Fund primarily focuses on capital appreciation. It invests in companies with high growth potential, typically in sectors or industries expected to expand rapidly. These funds reinvest profits or dividends back into the fund rather than distributing them to investors. This cycle continues until you decide to take out your investment. If you are looking for long-term wealth creation and are willing to accept higher risk, these funds can be a good option.
Why Dividend Mutual Funds?
Dividend Mutual Funds are designed for investors seeking regular income from their investments. These funds primarily invest in dividend-paying stocks or income-generating assets. Instead of reinvesting profits, they distribute dividends to investors periodically, such as monthly or quarterly. If you are looking for regular income from your investments, dividend mutual funds can be a good choice.
Instead of solely relying on total returns, investors must factor in their financial needs, long-term planning, tax applicability, and risk appetite before investing in dividend or growth mutual funds.
How to choose between growth mutual funds and dividend mutual funds?
The choice between growth and dividend mutual funds depends on your investment objectives and risk tolerance. You can look into dividend mutual funds if you want a regular income from your investments. If you are looking for a long-term investment, choose the growth option.
Can we switch from a dividend to a growth option in a mutual fund?
Yes. However, in mutual funds, switching from one option to another of the same fund is taken as a sale. Your old fund units will be sold, and new ones will be purchased. So, you will have to pay an exit load and capital gain tax based on the holding period of your investment.
What is the right time to invest in dividend mutual funds?
There is no particular time frame that is set to invest in dividend mutual funds. Depending on your investment objective, pick the right fund and invest.
Is dividend income on mutual funds taxable?
Yes. The dividend income on mutual funds is added to your annual income and taxed as per your income tax slab.
Can I invest in both dividend and growth mutual funds?
Yes, you can invest in both dividend and growth mutual funds to diversify your portfolio and align with your financial objectives.