Growth or Dividend Mutual Fund: Which is better for you?

What does the growth mutual funds mean?

The term "growth option" refers to an investment strategy in which the profits made by your scheme are re-invested rather than paid out to you. The scheme provides you with a type of compounding benefit, as you get the opportunity to earn profits on the previous profits. This investment strategy is the most effective way to increase your fund's net asset value (NAV). The growth option allows you to book the capital gain amount on redemption.

This type of investment plan is best for you if you want a corpus to meet future goals rather than a regular income.

How does the growth mutual fund works?

Suppose you purchase 1000 units of the XYZ mutual fund scheme at a NAV of Rs 50. After a year, the NAV had risen to Rs 60. If you sell your units in this case, you will receive a total of Rs 60,000, with a profit of Rs 10,000. However, if you stay invested and the fund performs well in the coming year, your NAV will rise even more.

What does the dividend mutual fund mean?

The only similarity between the growth and dividend reinvestment options is that you will not receive cash before redemption in either case. In the dividend reinvestment strategy, the dividend that is normally paid out to investors is instead reinvested in the scheme to buy more units. Choosing this strategy leads to an increase in the number of units held over time. If the market is favourable and the prices of the shares in your portfolio rise, the scheme's value rises as well.

How does the dividend mutual fund work?

Suppose you invest Rs 1,00,000 in XYZ mutual fund scheme, with a NAV of Rs 10 per unit. The total number of units that you will receive here is 10,000. 

Following your investment, the market performed exceptionally well, and your scheme's NAV increased to Rs 15 in a year with a dividend declaration of Rs 3 per unit.

In this case, the dividend is Rs 30,000, and the value of your dividend reinvestment plan is reduced to the extent the dividend is swiped out. It means your new NAV will be Rs 12.

The dividend of Rs 30,000 will now be reinvested, and the new units you will receive here would be 2,500 (30,000 ÷ 12). In this case, the dividend reinvestment plan increases your scheme's total units to 12,500 after reinvestment. Your investment will now be worth Rs 1,50,000. (12,500 units x Rs. 12)

Dividend vs growth mutual funds

After going through the above definitions, it should be clear that both of these investment options do not pay out dividends but rather reinvest them. So, what’s the main distinction here? The answer lies in the next table. 

Tax Implications of Dividend vs Growth Mutual Funds

One thing practically every mutual fund investor has to face forever is making choices between dividends and growth. The tax implications between these two are not similar, and thus, an investor must know the same.

Dividend mutual funds distribute earnings to investors on a regular basis, usually quarterly. These dividends have to go through DDT before reaching the investor. Once received, an investor may have to pay additional tax on these dividends if they are in a higher tax bracket as per their income tax slab.

In contrast, growth mutual funds reinvest the earnings back into the fund, which increases the NAV. Investors may pay taxes only when selling the units as capital gains. LTCG on equity mutual funds is taxed at 10% without indexation benefits, provided the gains lie above Rs 1 lakh in a financial year. For debt mutual funds, the tax rate depends on the holding period and the tax slab of both the funds and the investors.

Hence, the decision between a dividend and growth mutual fund should not be solely based on investment objectives, but also on the likely tax impact since this often is quite substantial in changing post-tax returns.

To conclude

The mutual fund house reinvests the dividend in both investment options, but in different ways. In case you prefer long-term investments and want to build wealth through compounding, you should consider a growth strategy.