Should you take money off the table or let it grow?

Investors are often flummoxed by the fund choices in the market. But even after you have homed in on a particular fund, the next question you have to consider is whether you should opt for the growth or the dividend option.

There are various factors that need to be considered while deciding between a dividend or a growth option. Also, your decision will hinge on whether you are looking to invest in equity or debt funds.

Here’s what you need to know before making the choice.

First, it helps to understand what the two options mean. Under the growth option, the gains that you make on your scheme are invested back into it. Hence, your returns are essentially the capital gains you make over the tenure of your investment. In the case of equity funds, there is no long-term capital gain on investments held over a year.

In the case of debt funds, short-term capital gains are taxed at your slab rate, if the investments are sold within three years. After three years, long-term capital gains tax is applicable at 20 per cent with indexation benefit.

Under the dividend option, the profits made on the scheme are distributed to the investor (quarterly, half-yearly or yearly). In the case of equity funds, there is no tax on the dividends declared by the funds. In the case of debt funds, while dividends declared by funds are not taxable in the hands of the individual, the fund house has to deduct taxes before distributing the dividend to investors. All debt funds attract a dividend distribution tax (DDT), and the effective rate works out to 28.8 per cent.

Keeping these basics in mind, let us look at the factors you must consider while choosing between the growth and the dividend options.

Since the dividends are not taxable and the holding period for long-term capital gains is only one year in the case of equity funds, your choice solely depends on your liquidity requirement and financial goals.

Generally, equity funds are considered a vehicle for long-term wealth creation. Hence, unless you reckon you will be able to re-invest the dividends at the same rate that your fund delivers, it would not be wise to opt for the dividend option.

Even if you are looking for a regular income, remember that dividends in equity funds are highly erratic, and you cannot rely on them alone for a steady income.

Also, the argument about tax-free dividends does not hold much water, as your capital gains are in any case exempt from tax after a year.

For these reasons, unless you absolutely want a (somewhat) regular payout, opt for the growth option in equity funds.

Given the DDT on dividends from debt funds, and the longer (three years) holding period for long-term capital gains, the choice is not that simple in the case of debt funds.

First, you have to understand that while dividends on debt funds are steadier and more predictable than on equity funds, there is still no guarantee about a monthly income, as dividends are paid only from surpluses and not from the capital.

If the fund does not perform well, it may not declare dividends at all. Hence, choosing the dividend option solely with an eye on regular income may not be such a good idea.

Second, as all debt funds attract a DDT of 28.8 per cent, for investors in the 10 per cent or 20 per cent tax bracket, the dividend option clearly is not very tax-efficient.

If your need is such that you require regular cash flows, the Systematic Withdrawal Plan under the growth option would be a better bet (provided there is no exit load). Under this, gains withdrawn from your debt fund will be taxed at your slab rate, which for a person in the 10 or 20 per cent tax bracket works out better than the dividend option.

For those in the 30 per cent tax bracket, though, choosing the dividend option may generate slightly higher post-tax returns than a withdrawal plan.

Dividend or Systematic Withdrawal Plans may interchangeably turn out to be a better deal for a different set of investors.

Opting for SWPs under the growth option of debt funds proved to be more tax-efficient until 2014, when gains made on debt funds held for more than one year, were treated as long-term capital gains and taxed at 10 per cent with indexation.

But after the 2014 Budget, capital gains made on debt funds held for less than three years are taxed as per slab rates, just like in the case of FDs, which removed the tax advantage.