This year in April, I made an investment in an equity fund's growth plan. The fund, in turn, issued the dividend re-investment plan to me. Although my financial advisor says that it does not really matter, I am somewhat concerned. I have invested Rs 2 lakh in the scheme and it declared a 10 per cent dividend in June. If there is no difference between the two options, then why would a mutual fund have two separate options?
Vivek Singh, via e-mail
Your financial advisor is either ignorant or is deliberately misleading you. After Budget 2003, dividend re-investment plan, in comparison to the growth plan, has become a more tax-efficient option for an equity fund investor. Budget 2003-04 has made dividend from equity mutual funds totally tax-free. Neither does the mutual fund pay any tax on dividend payouts, nor does an investor pay any tax on the dividend received. You should thank your stars that your fund moved you to the dividend re-investment option.
Now, a dividend is nothing but a part of your profits, which are paid out to you. Since the profit is re-inves-ted, it will further generate profits for you when the scheme generates returns. Basically, what a dividend re-investment option does is to convert your capital gains into tax-free dividends and then allows them to generate gains again. It is only when you book profits or exit a scheme that the gains are slapped with a tax. So, in effect, although you have made gains twice, you end up paying taxes just once.
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In the table (Growth & Dividend Re-investment), we have explained how these two options grow and how the dividends received are re-invested. You can see that in the dividend re-investment option, your profits are re-invested at the ex-dividend NAV while in the growth option, the number of units you hold remains the same. Thus, your cost of acquisition (Rs 11.09) is higher than what it was at the time you entered the scheme (Rs 10.43). The result of this dividend payout and re-investment is that your gains are also less as compared to what you would have got from the growth option. This lowering of gains also applies to the gains that you made on the units you had purchased initially. This happens because your initial gains were paid out in the form of dividends.
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Thus, the gain from the re-invested dividend is Rs 1.33 per unit (obtained as gain of Rs 2,301.05 divided by 1,729.08 units) while that from the original investment is Rs 1.99 per unit (gain of 3,8174.50 divided by 19,175.46 units) . On an average, the gain would be Rs 1.94 per unit. In comparison, gains from the growth option translate into Rs 3.11 per unit (one-and-a-half times more), which, in turn, means paying more tax. This can be seen from the table (The Tax Angle). That explains why the dividend re-investment option is better than the growth option. However, it is important to remember that returns from both options are the same—29.8 per cent—as the portfolio is the same. It is just that the tax treatment makes one option more profitable than the other.
This article was originally published on September 02, 2003.
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