Ask Morningstar: Growth or Dividend option?

By Mohasin Athanikar |  30-03-22 | 
 
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About the Author
Mohasin Athanikar is an Investment Analyst for Morningstar Investment Adviser India.

How does one choose between a growth option and a dividend option of a mutual fund?

Mutual funds pay dividends out of any investible surplus. When a fund house declares dividend, this dividend gets deducted from the Net Asset Value, or NAV. In essence, this is a return of your capital invested. This return of capital defeats the purpose of investing which is to grow your investment corpus.

Dividend options are used by investors seeking a regular income from their investments. Typically, retired folk who need a cash flow, or freelancers who deal with an unstable income, opt for dividends. If you have a steady income and are not dependent on your investment for periodic cash flow, you can go for the growth option.

What to note:

  • When it comes to dividend payout, you lose out on any gains that would have otherwise accrued on the income received. Hence, the corpus under the growth option would grow to a higher amount than one under the dividend option.
  • There is no guarantee on the amount or frequency of dividends. They are declared at the discretion of the fund manager and subject to distributable surplus.

Taxation:

Dividends are taxable in the hands of investors at their marginal rate of tax. Investors would therefore lose out on the favourable tax treatment on long-term capital gains offered by mutual funds. On this point, the growth option is better than the dividend payout option.

Till FY2019-20, companies deducted TDS before paying dividends to mutual funds. Subsequently, mutual funds also had to pay a dividend distribution tax (DDT) on dividends passed on to investors, which were then tax-free in the hands of investors. The Finance Act 2020 announced a change in taxation starting FY2020-21. Now, companies do not have to deduct a TDS amount while paying dividend to investors, including mutual funds. Mutual funds being pass through vehicles do not have to pay any tax on dividends received. However, now all dividends received (from both equity and other-than-equity oriented schemes) are taxed in the hands of the investors, at the marginal rate of tax, as applicable.

Additionally, mutual funds are required to deduct TDS (tax deducted at source) at 10% (excluding surcharge and cess) while distributing dividends exceeding Rs 5,000 to investors.

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