The dividend plans of mutual funds have been gaining popularity amongst the investors who look at them as an additional source of regular income. However, the plans do more harm than good. Through this article, we’ll understand why it is in everyone’s interest to ditch the dividend plans and opt for the growth option of mutual funds.
The word “dividend” refers to the profits realised by companies post fulfilling all its obligations, and which it is liable to pay to its shareholders. When companies whose shares are held by mutual funds declare dividends, it adds up to the total assets of the scheme, and the proceeds can be passed on to the investors.
Mutual fund houses offer two options for each of their schemes; the growth option and the dividend option. The former invests the extra returns back into the scheme, whereas the latter distributes a part of these returns in the form of dividends to the investors on quarterly, half- yearly or annual basis.
Myth Around Dividend Plans of Mutual Funds
There is one popular myth that surrounds the dividend plans of mutual funds. Most of the investors think that, similar to dividend income from companies, dividend from mutual funds is an additional return over and above the returns accrued from rise in Net Asset Value of the fund. However, this cannot be more wrong. The dividend declared by mutual fund houses is a part of the NAV of the scheme, which you happen to withdraw prematurely. Let’s understand this with the help of an example.
Suppose you buy a mutual fund unit for Rs. 20. After a year, the fund’s NAV rose to Rs. 27, and the fund decided to declare dividends. This dividend would be a part of your NAV, wherein the fund may decide to distribute Rs. 3 for each unit held in the form of dividend. After this declaration, the fund’s NAV will come down to Rs. 24. So, technically, you’re not earning any extra returns, you’re just taking out a part of your returns on a regular basis. This hampers the overall compounding effect on your investment portfolio and impacts the long term wealth creation goal negatively.
Why Opt for a Growth Plan?
Here are two key reasons why you should ditch dividend plans of mutual funds and opt for the growth option:
The most distinctive advantage of investment in mutual funds is the compounding effect on returns. If you reinvest the return from a particular mutual fund scheme, back into the scheme, you’re essentially augmenting your regular returns. If one opts for the dividend plan, a part of this extra return gets converted into dividend and distributed to investors. The compounding effect lessens, which is reflected in low returns in the long run.
Also, equity funds are meant for a long term investment horizon, and shouldn’t be looked at as avenues to obtain periodic income. The returns are exorbitant only if one reinvests the returns each year, so that your interest also earns interest during the tenure of your investment. The difference between the returns from the two options may not vary much in the first few years of investment, but as you remain invested for a long period of time, the power of compounding strengthens and you earn far more than what you’d have through the dividend option.
If an investor chooses to opt for the dividend plan of the mutual fund s/he has invested in, then the dividend income acquired in a financial year is added to the taxable income of the investor. This is not good for investors who fall in the higher tax bracket, say, 20%. When you compare it against the Long Term Capital Gains Tax of 10% beyond Rs. 1 lakh, you find that you’re actually paying more tax if you opt for the dividend plan. If looked at from the taxation perspective, one ends up paying more tax for dividend income as opposed to the capital gains accrued through the growth plan.
Over the years, we’ve noticed that the notion of dividend from mutual funds being an additional return has pushed thousands of investors to opt for the dividend plan of mutual funds. Now when it is clear that dividend plans do more harm than good to your long term financial goals, it is advisable to shift to growth options. These would have a significant positive impact on your investment, as it grows at an exponential pace. Happy Investing!
