While applying for an SIP, investors need to mention, out of growth, dividend reinvestment and dividend payout, which option they want to opt for.
Systematic Investment Plans (SIP) are becoming popular among young investors to build wealth through long-term investments in equity Mutual Funds (MFs). Traditionally, Indian investors are risk-averse and prefer only guaranteed investments like bank fixed deposits (FDs), but despite market risks, new-generation investors are ready to take calculated risks through SIP as periodic investments in both high and low market cycles average out the risks and enhance the possibility of higher gain in the long term.
However, while applying for an SIP, investors need to mention, out of growth, dividend reinvestment and dividend payout, which option they want to opt for. So, in case you are going to start an SIP, you should know about implications of the three options.
Asset Management Companies (AMCs) run various MF schemes and according to the investment objectives, fund managers invest the fund money to various instruments. Equity MFs predominantly invest in equities, i.e. stocks of various companies.
Stocks of the companies fluctuate in short run along with fluctuations in the stock markets, producing short-term gains or losses. However, if chosen properly, companies generate long-term returns as the grow over a period despite short-term fluctuations.
By selecting the growth option, MF investors enjoy the long-term growth of the underlying stocks in the portfolio as the Net Asset Value (NAV) of the schemes also grow. Once the financial goal, to fulfill which investors started the investment nears, they may redeem the units to withdraw money when market situations are good to maximise the return. As per the current income tax rule, if total long-term capital gain (LTCG) out of total equity investments exceed Rs 1 lakh in a financial year, 10 per cent LTCG tax will be imposed on the gain exceeding Rs 1 lakh.
On the other hand, dividends are declared according to pre-decided intervals when MF schemes realise sufficient gains. So, first of all, there should be gain, which comes either through appreciation in underlying stock prices or on receival of dividend paid by the companies comprising the portfolio.
However, companies declare dividend from the amount left after deducting all the expenses from revenue and paying income tax on leftover profit and after transferring the amount to reserve as decided by the directors. Even while distributing the amount earmarked for dividend after paying corporate tax, companies again need to pay Dividend Distribution Tax (DDT) to the government.
In the same way, DDT is also paid on dividend distributed by the MFs out of the realised gains. The rate of DDT for equity funds is 10 per cent, while it is 25 per cent for debt funds. So, dividend is subject to double taxation.
Although, dividend reinvestment option is similar to growth option, but DDT plays a spoilsport, and hence growth option provides better return than the dividend reinvestment option.
The dividend payout option ensures a regular income in the hands of investors, but apart from the DDT, 10 per cent tax is imposed again if total dividend received in a financial year crosses Rs 10 lakh.
So, due to excessive taxation on dividend, it is better for you to opt for growth option. If regular income is needed, you may start Systematic Withdrawal Plan (SWP) when LTCG becomes applicable to reduce the tax outgo.