From the Dark Ages of investment history, when the whole world invested in shares alone- you would remember the dividend letters coming home. Do you think the dividend option in mutual funds is akin to these corporate dividends? Well, No. And this is where the problem begins. Allow us to simplify it for you.
Dividends are, by definition, a part of the profits made that are distributed to the investors. This itself makes the mutual fund definition of dividends null and void. Primarily because what the fund is sharing with you is basically your own money to start with. This is very contrary to dividend on shares, where the company shares a percentage of profit with the investor over and above the share price increasing. To give you an example of a mutual fund dividend, if you have a fund of Rs 100 and the fund house may decide to pay you a dividend of Rs 3, the value of your seed money goes down to Rs 97. So, the overall impact is your investment sum reducing while you basically are only withdrawing from your own account.
Let us look at some disadvantages of dividend options in mutual funds-
- Growth Vs Dividend – The growth option is the alternative to dividends in mutual funds. Simply put, it allows no mid-term/haphazard – interests/gains/profits to be shared with the investor. The only gain the investor has is from when he/she chooses to sell the fund. The money gained is due to the difference in NAV at the time of buying and selling the fund.
The beauty of this is the power of compounding. Of course, you won’t be able to see this beauty in your bank account at regular intervals but the longer your seed money is invested for, the more returns you gain. That’s the thumb rule. Dividend option defies this logic by alluring the customers with regular pay-outs. But that quite beats the overall purpose of mutual fund investment i.e. compounded capital gains.
Let us look at an illustration to better explain the difference in returns in Growth option vis a vis Dividend option. Here we have made the following assumptions-
- Dividend Reinvestment portfolio with a dividend distribution tax of 11.65%
- 10% annual dividend and 12% rate of return
*The above illustration does not take inflation into account
**The above illustration is only for understanding purposes
So, in effect, the difference is the money that has been paid as tax over a period of 10 years, out of your own investment. An unnecessary debit.
- Taxation Issues – Now, let us come to the most pressing issue. For e.g.: If the total dividend value is Rs 10,000, the fund house needs to pay a tax of 11.65%(assuming the investment made is for more than 12 months) before paying it to you. Hence, what you get is Rs 8,835. So, in effect, you are not even getting your full share of profit. In contrast, the long-term capital gain tax on equity funds is payable only post selling the fund.
- The reinvestment myth – A popular culture is that of dividend reinvestment. The concept of reinvestment mandates the dividend to be reinvested. That would imply-
- Firstly, a part of your money has been permanently paid as tax.
- The next time dividends are paid, there will be further taxation on this money.
- And, there will possibly be a long-term capital gain tax if you decide to withdraw the whole amount (depending on the amount and period of investment)
Now that’s a lot of unnecessary taxes being paid!
Dividend options need to be avoided. Investors looking for regular incomes from their investments may just withdraw money as and when required or opt for Systematic Withdrawal Plans (SWP). But must keep in mind that the need for this regular income should stem out of a real necessity. Otherwise, the money is better left alone to grow.
Be wise with your financial planning, get in touch with our financial advisors to help you get started with the right investments !!!