1. Growth Option
If you select the growth option in a mutual fund, you will not get any dividend. But the gains made by the fund will be reinvested. This will be reflected in the Net Asset Value (NAV) of the scheme. NAV of the growth plan will be higher than the dividend option. The investors who opt for the growth option will benefit when they sell their units at a higher NAV.
2. Dividend Option
In dividend option, the fund will pay you dividends out of the profits made by the fund. But the declaration of dividend is not guaranteed and it will depend on the profits generated by the fund. Dividends are declared as a percentage on the face value of the units. Suppose the NAV of a fund is 30 and if it declares a 20% dividend today. It means an amount of Rs.2/- per unit will be paid. (20% of the face value Rs. 10/-). But after the payout of this dividend, the NAV of the fund will fall to Rs. 28/-, which is called the ex-dividend NAV.
Please note that the dividend is not an extra benefit paid. The amount paid as dividend is reduced from the NAV immediately. So, in effect, it is only a way of returning a portion of your money to you.
3. Dividend reinvestment option
In dividend reinvestment option, the declared dividend is not paid to the investor, but is used to buy further units of the scheme. So, the number of units will increase after each dividend declaration. The units are purchased at the ex- dividend NAV of the scheme.
HDFC Top 200 fund was started in September 1996 with an NAV of Rs. 10/-. As on 26th November. 2012, the NAV of the fund under growth option is Rs. 212. In the case of dividend option, the NAV is 42/- only, because the fund was paying lot of dividend in these 16 years.
Which is better? Growth or Dividend?
You should select an option, as per your personal financial goals and tax liability.
If you are investing for long term goals like retirement, children education and marriage, it is better to opt for the growth option. This option is ideal for this because of the capital gain it offers over the long term. If you opt for dividend option, the dividends paid will reduce the NAV and you may not get the desired amount for the goal.
But, if you are looking for a regular income from your investments, then you can opt for dividend option.
But please not that dividend option will not declare dividend at fixed intervals. The payment dates and the amount of dividend are decided by the fund house.
Effect of taxation on various options
The effect of taxation is different for various schemes.
Long term capital gains from equity mutual funds are tax free as per the current tax laws. If you are investing for more than 1 year, it is better to opt for growth option and get the benefit of tax free capital gain. This is why it is said that mutual funds are tax efficient investments.
But, if you are selling the mutual fund units within 1 year, the gains will be treated as short term and will be taxed at 15%. In such cases, it is better to go for dividend option, because the dividends are tax free. There is no dividend distribution tax in equity mutual funds.
Dividends from debt mutual funds are tax free, but there is dividend distribution tax (DDT), paid by the fund. In the case of Liquid funds, the rate of DDT is 25%, while in the case of MIPs, Debt Funds it is 12.5%.
If you redeem your investment after 1 year, the gain will be treated as long term and will be taxed at a flat rate of 10% or at 20% with indexation benefits. Indexation will help you to offset inflation and the tax liability will be very less, in periods of high inflation like this. This is why it is said that you should invest in debt mutual funds. Growth option will be better if the duration of investment is more than 1 year.
But if you redeem your debt mutual funds within 1 year, any gains made will be treated as short term and you have to pay tax on it as per your income slab. If you are in the 10% slab, growth option is better for you. This is because the Dividend Distribution Tax is 12.5%. But, if you are in the higher slab of 30%, dividend option is better, because DDT is less than your slab rate.
The mutual fund investments are generally for long term. In that case, it is better to opt for growth option for both Equity and debt funds.