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Are dividend reinvestment plans of mutual funds good?

Ashutosh Gupta explains the pros and cons of dividend reinvestment plans

Are dividend reinvestment plans of mutual funds good?

What's your opinion about the dividend reinvestment plans of mutual funds?
- Manjunatha Upadhyaya

I would advise against investing in dividend reinvestment plans for their tax inefficiency. In a dividend reinvestment plan, whatever dividend is announced by the fund from time to time does not hit an investor's bank account. It is automatically reinvested in the units of the same fund. So the investor ends up getting more units worth the dividend amount of the same fund.

In this round-tripping, the investor does not get any dividend in hand and yet ends up paying taxes on it. When filing the income tax return, the dividend is added to the investor's income and taxed as per the slab system. So clearly, the growth plan should be a preferred mode for most investors.

If we get into the weeds, one can pull out a very limited use case for someone below the threshold limit of taxable income. For such an individual, the dividends would become tax-free, and because over the long term, the subsequent dividend reinvestments hopefully happen at higher NAVs. So that reduces the accumulated gains and therefore lowers the capital gains tax liability when eventually the investor redeems these units.

But again, there is a downside: the dividend reinvestments happen after deducting the TDS if the dividend amount is more than Rs 5,000, and there is an opportunity loss associated with it. Secondly, you also end up converting your long term capital gains into short term capital gains. That is why I would say that investors should, by and large, avoid dividend reinvestment plans.

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