Most mutual funds have multiple options for investment, for the same fund:
1) Growth option
2) Dividend option
(with either automatic reinvestment or as a payout)
The "funda" behind Dividend is that the fund gives you "cash" regularly, and this can be either paid to you or reinvested in the fund (more units are purchased on the day of the dividend disbursement, at the NAV of that day). Note here that dividends are paid out of the assets of the fund, therefore the Dividend option's NAV will go down when dividend is paid.
Dividend payout is usually taken by people who want some cash return on their investments, which supplements their income.
The dividend re-investment and growth options are similar, in the sense that your dividend adds on to your investment and compounds itself. So why two different options?
That's based on history. Earlier, your capital gains were taxed at 20% (long term) and 30%(short term). Dividends were taxed at 10% and later, not taxed at all. Growth option funds only had capital gains (since there was no dividend) and when you wanted cash you would pay a HIGHER amount of tax. Dividend reinvestment ensured that your dividends paid lesser tax and the re-investment, being usually at a higher NAV since the fund is growing, will attract less capital gains tax.
But now the equation has changed. Currently, Dividends are not taxed in your hands. (and equity mutual funds aren't charged a dividend distribution tax) Also, with the Securities Transaction Tax regime, you pay a 0.25% STT on the sale of your fund units, and therefore the law says that short term capital gains tax is 10% and long term capital gains are not taxed!
So what's the difference now? One factor to consider is that some funds must pay dividend distribution tax at 12.24% - this does not apply to equity funds. Obviously this affects the dividend options but not growth options of funds.
Further, there's capital gains. Let's say you invested in a fund 5 years ago, in "dividend reinvestment" and now you want money urgently. Some of the units you got as part of the dividend reinvestment were perhaps given to you in the last one year; selling those will mean a short term capital gains tax of 10%! If you had chosen the growth option, you would pay no capital gains tax (as all gains are long term = greater than one year of holding).
Always choose the Growth option. If you need cash regularly, choose the Dividend payout option. Don't really bother with Dividend reinvestment (unless tax laws change).
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