When you select an equity or debt fund to invest in, there is also a choice between growth and dividend plans. There is also the dividend reinvestment plan but that is not too popular. The choice is normally between a growth plan and a dividend plan. For example, if a fund has a NAV of Rs.20 and it has declared a dividend of Rs.3 on its dividend plan, then the Growth plan continues to have a NAV of Rs.20 while the Dividend Plan holders receive Rs.3 as dividends and the NAV goes down to Rs.17. So, you can say that the wealth impact of dividend payouts is nothing significant as the dividend is paid out of the corpus and to that extent the corpus gets depleted. Despite this conceptual similarity, there is an important choice that investors need to make between growth plans and dividend plans of mutual funds. Here is why and here is how the decision between growth plans and dividend plans must be made.
Unlike in growth plans, the dividends don’t get reinvest in the dividend plan
When you receive the dividend into your bank account, quite often you already have an expense planned against it. Therefore, you don’t reinvest the dividends but instead use it for other purposes. Remember that when a fund declares dividend it is paid out of the NAV of the fund. Therefore the NAV of the dividend plan will get reduced to that extent. Let us look at the Kramer Equity Fund in the table below…
|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|
On the face of it, in terms of wealth both the dividend and growth plans are the same. It is just that Rs.4 has been paid out in the dividend plan but has been reinvested in the Growth Plan. That is what has ultimately made all the difference. The problem is that if this Rs.4 taken out as dividend is not reinvested then you lose out on wealth creation. That is why from a long term wealth creation perspective; it is growth plans that work best in creating long term wealth.
Therefore, logically growth plans are better for long term planning
This follows as a logical corollary to the previous point. When you plan for long term goals like retirement, child’s education or marriage, you must ensure to make the power of compounding work for you. Otherwise, it does not matter how much you invest and how much risk you take, you will find it hard to generate wealth over the long run. Such wealth creation can only be enabled if the returns are constantly reinvested in the fund. A growth option is an auto wealth compounder and hence more compatible with long term wealth creation via equities
Don’t forget the problem of double taxation in equity funds
Did you know that dividend plans in equity funds are not exactly tax efficient? Here is why! The LTCG tax on equity funds introduced in the 2018 budget will have only a marginal impact and even then you have the choice of annual withdrawal to keep your tax outflows in check. Although, long term capital gains (LTCG) are taxed at 10%, growth options will be more meaningful. Post Budget 2018, equity funds will be subject to double taxation. The company will deduct dividend distribution tax (DDT) on the dividends it pays to the mutual funds. Then the mutual fund will again deduct DDT at 11.648% (10% DDT + 12% Surcharge + 4% cess) and only pay the net dividend to the fund holder. That amounts to double taxation for the investors.
Leave aside equity funds; even for debt funds growth plans are more meaningful
Is it really true that growth plans are better suited to debt funds too? The answer is yes and here is why! When a debt fund declares dividends then the dividend distribution tax (DDT) is deducted by the fund at 29.12% (25% DDT + 12% Surcharge + 4% Cess). Instead, if you are invested in a debt fund growth plan for more than 3 years, then it will be classified as long term gains. In that case, you pay 20% tax with benefit of indexation. That is economical!
Worried about regular incomes; SWPs could be the answer
Conservative investors and retirees often argue that if you opt for a growth plan then you do not get regular income to meet their routine needs. The idea is that the debt fund pays a higher return than bank FDs and that acts as an added advantage. There is a solution to this problem called SWP. You can structure a Systematic Withdrawal Plan (SWP) such that each month you withdraw a part of the capital and a part of the returns. Now comes the interesting tax part! You pay capital gains tax only on the return portion and not on the principal portion making it more tax-efficient, even while ensuring regular income.
Considering the dividend taxation and the need to create wealth, the growth plans make more sense for long term investors. Even for debt fund investors, the withdrawals can be structured as an SWP instead of a dividend.