Mutual funds are investment vehicles that pool together money from multiple investors and use it to purchase a diversified portfolio of stocks, bonds, or other securities. They are managed by professional portfolio managers who are responsible for selecting the securities and managing the overall portfolio. Mutual funds can be especially appealing for investors who do not have the time or expertise to manage their own investments or who want to invest in a specific asset class, such as stocks, but do not want to deal with the complexities of selecting individual stocks.
To invest in a mutual fund, you simply need to send money to the fund and you will be issued a certain number of units in the fund based on the current value of the securities in the portfolio. The value of your mutual fund units will fluctuate based on the performance of the underlying securities, and you can sell your units at any time to realize any gains or losses. While investing in a mutual fund an investor needs to choose between the Dividend and Growth option of investment. The features and practicality of these two options are highlighted in this article.
Income Distribution cum capital withdrawal, earlier referred to as “Dividend Pay-Out” option of mutual funds, shows the actual income earned by an investor. Under this option, dividend is declared by the fund from time to time subject to availability of profits. When dividend is paid by the fund, the Net Asset Value (NAV) of the units allocated to the investor falls to that extent. However, there is no change in the number of units held by the investor.
The investor in the dividend option may get dividend declared by the fund as well as capital gains (or losses) on sale of units. The investor receives the dividend paid by the fund in his/ her bank account and such dividend received is taxable in the investor’s hands.
In the Growth option, no dividend is declared by the fund and there is also no change in the number of units held by the investor. Thus, NAV of the units held under this option is higher and it captures the full value of portfolio gains. The investor in the growth plan thus earns capital gains (or losses) on sale of units of the mutual fund.
SUMMARY OF IMPLICATIONS OF MUTUAL FUND OPTIONS:
Parameter | Income Distribution cum capital withdrawal option | Growth Option |
|---|---|---|
Declaration of dividend by the fund | Yes | No |
Receipt of dividend in investor’s bank account | Yes | Not Applicable |
Taxability of dividend | Yes | Not Applicable |
Change in Net Asset Value (NAV) | NAV reduces to the extent of dividend paid | NAV reflects the gain/ loss of the full portfolio |
SUITABILITY
Dividend and growth options are two different types of mutual fund investments, and the choice between them will depend on the individual investor's goals and financial situation.
Dividend options are suitable for investors who are looking for a steady stream of income from their mutual fund investments. These options may be appropriate for investors who are retired or nearing retirement, or for those who rely on investment income as a significant part of their overall income. Dividend options can provide a regular source of cash that can be used for expenses or reinvested in other investments. However, it is important to note that dividend by the fund is declared only when there is distributable surplus. Therefore, dividend in such a case is not guaranteed even if the investor opts for monthly dividend option as it depends on availability of distributable surplus.
Therefore, for this reason, it may be preferable for investors looking for regular income to choose Systematic Withdrawal Plan (SWP) of mutual funds for the required amount. Dividend income received under this option is taxable and this affects the investor’s return, thus making it a preferable option only for tax-exempt investors.
Growth options, on the other hand, are more suitable for investors who are looking to maximize the long-term appreciation of their investments. These options may be appropriate for investors who are younger and have a longer time horizon for their investments, or for those who are looking to build wealth for the future. Growth options typically do not pay dividends, but the value of the investments may increase over time as the underlying assets appreciate in value.
TAX EFFICIENY
Growth options for mutual funds are more tax efficient than dividend options because they do not pay dividends and therefore investors do not have to pay tax on the dividends received. Instead, the value of the investment increases over time as the underlying assets appreciate in value. When an investor sells his mutual fund investment in a growth option, he may have to pay capital gains tax on any profits made. However, the tax rate on capital gains is typically lower than the tax rate on dividends, so growth options are more tax efficient in this respect. This concept is also referred to as deferment of taxes and provides the investor the benefit of compounding before tax.
In India, profits realised from mutual funds attract capital gain tax in the following manner:
Nature of Capital Gain | Equity-oriented Mutual Funds* | Non- equity oriented Mutual Funds |
|---|---|---|
Short term capital gain | 15 percent. This is applicable to funds held less than 1 year. | Marginal tax rate as per investor’s tax slab. |
Long term capital gain (exempt up to Rs. 100,000/-) | 10 percent without indexation. This is applicable to funds held for more than 1 year. | 20 percent with indexation. This is applicable to funds held for more than 3 years. |
*Equity -oriented mutual funds hold more than 65 percent of assets under management in equity shares listed on recognised stock exchanges in India. All other funds are classified as non-equity oriented mutual funds.
Exploring Alternatives: How Systematic Withdrawal Plans Offer Tax-Efficient Regular Income for Mutual Fund Investors
The dividend option of mutual funds is a popular choice among investors who want regular cash flow, but are not happy with the low returns offered by fixed deposits and government schemes. However, this option has its drawbacks, such as limited cash flow and infrequency of dividends.
Besides, the dividends received from mutual fund investments are taxed according to the investor's income tax bracket. For example, if an investor falls in the 30 percent tax bracket, he will have to pay 30 percent tax on dividends received. Similarly, if an investor falls in the 5 percent tax bracket, he will have to pay 5 percent tax on mutual fund dividends. This tax structure has made the dividend option less attractive for investors in higher tax brackets. An important point to note here is that long-term capital gains (LTCG) @10 percent is applicable to gains on equity funds held for over a year, with the first Rs 1 lakh being tax-free. Thus, the investor would be paying tax @10 percent instead of 30 percent and also getting a tax exemption of Rs 1 lakh on LTCG just by waiting for a year to redeem the units and by choosing the growth option of equity mutual funds. Short-term capital gains (STCG) tax @ 15 percent is for applicable to funds where investments are held for less than a year. Therefore, it may be more tax-efficient for investors in higher tax brackets to take their returns as capital gains rather than dividends, which would be taxed at their individual slab rate, thereby increasing their tax burden.
An alternative for such investors is to opt for a Systematic Withdrawal Plan (SWP). This allows for more control over the amount and frequency of cash flow. For example, if you have a corpus of Rs 20 lakh in a mutual fund, you can set a withdrawal amount of Rs 20,000 per month. This will reduce your investment amount by Rs 20,000 each month but would provide you a monthly source of income and also allow the remaining funds to continue to be invested and grow and potentially earn more returns. Staying invested for longer periods aids the process of wealth creation and helps you achieve your financial goals.
Systematic Withdrawal Plan (SWP) is a tax-efficient way to receive regular income from equity funds as it allows the investor to benefit from the tax imposed on long-term capital gains, up to an amount of Rs 1 lakh. This means that the investor only pays tax on gains over and above Rs 1 lakh. Overall, it is suggested that investors should use the growth option rather than the dividend option as the long-term growth potential is greater and by combining the growth option with the SWP option, an investor can fulfill the need for regular cash flow. Besides, the growth option also helps to defer taxes and compound returns for the investor.
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