Thursday, February 15, 2007

Mutual funds - Growth vs Dividend - What should we choose?

Some time back I had posted an entry where I had recommended that in mutual fund world, choosing the 'Growth' option is the way to go and the 'dividend' option whether you take the cash out or you reinvest it, is really a pain from a management perspective. I have been thinking about this choice further and I want to refine my recommendation a little bit more considering the current tax laws prevalent in India.

Indian tax laws for equity mutual funds (funds that invest > 65% of their corpus on common stock) specify that

  1. Short term ( less than one year) capital gains tax is 10%
  2. Long term capital gains is 0%
  3. Dividends paid are non-taxable
  4. Security transaction tax (STT) of 0.1% has to be paid on all SELL transactions

Indian tax laws for debt mutual funds specify

  1. Short term capital gains is treated as income (basically added to salary and taxed at the tax bracket you belong to)
  2. Long term capital gains is 10%
  3. Dividends paid are non-taxable in the hands of the investor but they undergo a tax called dividend distribution tax (DDT) (12.5% + surcharge + education cess) that the fund has to pay before declaring dividend. This effectively reduces the quantum of the dividend in your hands
  4. There is no STT.

So if you are in the highest tax bracket, it might make sense to opt for the dividend option when you are buying debt mutual funds since effectively you pay onl 13.xx% as tax on the dividend as DDT as compared to growth option.

For equity mutual funds, the verdict is very clear folks - growth is the direction in which you should be going.


Vishal said...

That's an excellent opinion. Though the choice between dividend and growth is usually decided by my liquidity requirements in the future or my requirement for cash in the near future.

P.S. I do wish you would write more frequently

Vivek Venugopalan said...

Vishal - I am not sure why your cash flow/liquidity needs determines growth or dividend option. Can you elaborate more on this?

yes even I wish I could write more often... :-)

Vishal said...

Well, by going in for a dividend option, even though it would be an undetermined amount, I can enjoy the dividend as extra cash to be added in my immediate liquid (read cash) funds. I understand this is an amount I cannot really count upon but whatever I get would be something akin to a bonus :)

Vivek Venugopalan said...

aha - Now I get it. You are spending the dividends :-). Well in an ideal world you are supposed to re-invest them in another vehicle to earn more money but I am just as guilty of spending as anybody else.

Actually one's asset allocation determines the equity to debt mix and thus determines how much money should go into debt funds which would in turn give you dividends (if invested in the way I have called out in my post) thus you would know the quantum of investment that goes into debt. Further, debt funds have traditionally yielded in the range of 6-9% thus your extra income can be determined to a large extent and not really an unknown.

investar said...

What if they change the law in the future that the Capital gains will be taxed? Wouldn't that mean if you have accumulated capital gains for long (say few years), and if the law changed, you will be taxed on all the capital gains whereas someone who had opted to have the dividends reinvested would pay much less tax on the capital gains? Also, could you shed some light on the hassles involved with the dividend reinvestment option? I appreciate your response. Thanks!

Arvind said...

Not sure if I understood your calculations correctly.
Still feel growth would be the way to go, even in the case of debt funds should you sell your assets beyond a year. In this case your gains would qualify for long term capital gains taxation which would be lesser than the DDT you would have otherwise paid.
If that's what you meant don't think it came out quite clearly in the blog.