What are Dividend Funds: When to opt for them & when to avoid them?
When investing in the mutual fund an investor has two options, growth or dividend. In case of growth option, profits made by the scheme are reinvested. This results in the rise in the Net Asset Value (NAV) of the scheme over time, whereas in dividend option the profits made by the scheme are not reinvested. These profits are distributed as dividends to the investor time to time. There is no fixed time and amount of dividends. Dividends are only made when the scheme makes a profit and is paid from NAV of the unit. In long run, one can seek the benefit of compounding in growth option as compared to dividend option, while dividend option can be opted for regular income.
The concept of Dividend Funds:
A mutual fund scheme can declare dividends for its unit holders from the profits realised in the mutual fund scheme. In funds, dividends are not an additional income but just a withdrawal from the investments thus reducing the Net Asset Value of the fund. For example, if your investment value is Rs. 10 lakhs and the fund announces a dividend of Rs 30000, then after the dividend the value of your investments becomes Rs 9.7 lakhs. A regular dividend from company shows that company prospects are positive. When a mutual fund declares dividend it’s different. They declare to create a positive perception. Usually, investors often confuse themselves for mutual fund dividends with company dividends and treat them as a net gain. Also it gives a sense of security to book regular profits and distributes it as a dividend in a rising market which in turn reduces the risk of equity schemes.
Taxation of Dividends:
The dividends received from all mutual funds are tax free for the investors. In equity mutual funds there is no dividend distribution tax. In case of debt funds the AMC pays a dividend distribution tax of 28.84% inclusive of surcharge and cess.
Dividend reinvestment option and how is it different from growth option:
The dividend reinvestment option is different from growth option. In case of dividend funds the dividends would otherwise be paid out to investors but in dividend reinvestment option they are reinvested to purchase more shares in the fund. The cash generated in order to pay dividends is re invested is used to purchase more units for the funds. The investors enjoy capital gain both in growth and dividend reinvestment option upon sale of units but in case of dividend reinvestment option the fund units have now increased more than what they started off with.
Dividend re-investment plan can be useful if the investor is in 30% tax bracket and investing in debt funds for a horizon of less than 3 years as in this case he has to pay 28.84% tax opposed to 30% tax of growth option.
When to opt for Dividend Funds:
- Regular Income:
If the investor needs a regular income over a period of time than the investor should opt for Dividend fund. In this case, the investor will get dividend/ profits declared by the company thereby reducing the Net Asset Value of the Fund. Remember this is different from investing in equities and earning a dividend from it. Here dividend payouts are like redemption, they come at the cost of NAV.
- Short-term investment goal:
You should opt for dividend funds only when you have short/medium term investment goals with some expectation of income in between. This will assure that your basic short-term needs are fulfilled because of the regular flow of income.
- Retired investors:
Post-retirement one can opt for this option. Since after retirement if you want a flow of income which full fills your needs post your retirement than you can opt for dividend option in debt funds. However, bear in mind that dividends are not guaranteed.
When to avoid Dividend funds:
- Growth perspective:
In case if you want your investments to grow over a period of time then one should avoid the option of dividend funds as the profits made by the growth option in the fund are ploughed back into the fund. The Net Asset Value of the fund appreciates over time and no dividend is paid out during the entire tenure of the holding. Income under this option is only receivable when there is a sale of such units. Thus one doesn’t receive the income as in case of Dividend option.
- Long-term goal:
Investors with a long-term goal must also avoid the dividend option. In the long term, power of compounding works which multiplies your investments which won’t be possible in dividend funds as there would be no growth.
Dividends though are not guaranteed and depends on the fund performance, can help in earning regular income, especially in case of debt funds, where the risk is less. Hence, investors in need of regular income can go for dividend funds and the investors with long term horizon can avoid dividend option.
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