In investment, the term dividends refers to a compensation publicly listed companies offer their shareholders from their net profits. This compensation can take various forms, including cash payments, cash equivalents, or additional shares in the company. While investing in mutual funds online, investors generally choose between the growth and dividend options to receive mutual fund returns.
Not all mutual funds in India offer dividends to their investors. Investors must understand the concept of dividends in mutual funds and how companies compensate investors using them before investing in mutual funds. One key decision investors face when entering the world of mutual funds is whether to opt for the “growth” or “dividend” option.
What are dividends, and how do investors earn them?
Dividends are compensations that publicly listed companies offer their shareholders after earning profits. In mutual funds, dividends represent the portion of the fund’s earnings distributed to investors. When one invests in a mutual fund, they essentially become a shareholder in a portfolio of stocks, bonds, or other securities. The income generated from these investments, such as interest, dividends, or capital gains, is passed on to the investor. Mutual funds offer two primary options for investors: the “growth” option and the “dividend” option.
The “growth” option focuses on increasing the value of investment over time. Mutual fund companies achieve this by reinvesting any earnings or gains into the fund, thus increasing the Net Asset Value (NAV). Essentially, an investor’s wealth grows as the fund’s portfolio appreciates, and they benefit from capital appreciation when they decide to redeem your units. The growth option may be suitable if investors are looking for long-term wealth accumulation and are comfortable without periodic income payouts.
What are the features of dividends, and how do they impact mutual fund returns?
Investors can compare mutual funds based on the dividend and growth option and decide the one that suits them the best:
- Mutual fund companies subtract dividends from the NAV
When an investor chooses the dividend option in a mutual fund, they are choosing to receive periodic income payouts. The mutual fund company makes these payouts from the fund’s earnings and distributes them regularly. However, they must note that when companies pay dividends, they subtract them from the fund’s Net Asset Value (NAV). Therefore, the NAV of the fund falls by the amount of the dividend distributed. Consequently, after the dividend payout, the NAV of the fund is lower than it was before.
- The dividend option offers lower growth as compared to the growth option
The dividend option provides investors with a stream of income, which can be advantageous for those seeking regular cash flows. However, since dividends are paid out regularly, the fund may not be able to reinvest these earnings for growth effectively. As a result, the long-term capital appreciation potential of the fund may be lower compared to the growth option. Investors who prioritize regular income should carefully consider this trade-off.
- The I-T department taxes dividends at the investor’s income tax slab rate
In India, dividends from mutual funds are taxed in the hands of the investor at their applicable income tax slab rate. This means that the tax liability on dividends can vary significantly from one investor to another. In contrast, the growth option allows investors to defer taxation until they redeem their units, potentially leading to tax savings in the long run.
- The dividend option favours investors who want a steady income flow
Despite the potential drawbacks, the dividend option can be a suitable choice for investors who rely on their investments to generate regular income. Retired investors or individuals seeking supplemental income can use the dividend option to earn an additional income.
Investors must consider the impact of dividends on their overall returns before selecting any of the two options. When deciding between these options, investors must consider their financial goals, risk tolerance, and financial needs. If they prioritize long-term wealth accumulation and can do without regular income payouts, the growth option may be more suitable. However, if they require steady income flows from their investment, the dividend option can serve their needs. Consider the impact of dividends on mutual fund returns before deciding to invest in mutual funds online.
