If you're a bank FD investor who usually prefers regular interest payouts over the cumulative option, you may be inclined to sign up for the dividend option of a debt fund to ensure regular income. But when it comes to debt funds, the growth option is vastly more tax efficient than the dividend option.
Both the growth and dividend options of debt funds earn their returns from the same underlying portfolio. But when debt (or hybrid debt) funds declare and pay out dividends, they suffer a 28.3 per cent dividend-distribution tax at source. You do not directly pay this tax, but it nevertheless eats into your returns as a debt-fund investor because the fund pays it from your returns. Suffering this 28.3 per cent tax on your income can be particularly damaging if you're in the 10 or 20 per cent tax bracket.
The returns you earn by redeeming your units in the growth option, however, suffer lower rates of tax. If you redeem units within three years, your capital gains will be taxed at your income-tax slab rate as short-term gains. If you sell after three years, the returns are subject to long-term capital-gains tax at 20 per cent. But this is after adjusting your returns for inflation (indexation benefits). In effect, by holding your debt funds for three years, you will ensure that you pay taxes only on the inflation-adjusted returns. The effective tax rate would work out to be far lower than for bank FDs or other debt options.
Therefore, pensioners or retirees looking for regular income from debt funds should opt for the growth plan and set up a systematic withdrawal plan (SWP) to redeem a fixed sum from the scheme each month. The SWP route gets you a predictable cash flow and also sharply reduces your tax outgo on returns as the sums you earn after the first three years will suffer very little tax.