GOOD AND BAD ABOUT DIVIDEND MUTUAL FUNDS

DIVIDEND MUTUAL FUNDS ALLOW YOU TO ACCESS YOUR PROFITS OR REINVEST THEM FOR FURTHER GROWTH

Dividends are payments made by a company to its shareholders — essentially, a distribution of the company’s profits. Dividends can be earned from both equity and debt mutual funds. A mutual fund — be it equity or debt — can have two broad variants: a growth plan or a dividend plan. In growth funds, dividends are re invested allowing you greater capital growth. But in dividend schemes, dividends are paid out periodically. Dividends allow you to develop an additional stream of income.

But they also mean lower capital growth on your mutual fund investment. So what are the pros and cons of investing in dividend funds? More importantly, is there a category of investors who should go for dividend plans? Who should avoid them? Here is an in- depth look at dividend funds to help you invest smartly.

WHAT ARE DIVIDEND MUTUAL FUNDS?

Simply put, your investment in dividend mutual funds makes you eligible to earn dividends. Equity mutual funds invest in stocks that pay dividends periodically. Debt mutual funds also invest in bonds that pay dividends. Dividend funds can have two variants. One, the dividends are paid out periodically at the fund manager’s discretion. Two, the dividend is reinvested in the fund to buy additional units of the same fund.

HOW DOES THE DIVIDEND PAYOUT HAPPEN?

Dividend payouts can have various frequencies: daily, monthly, quarterly, or annual. Some funds can have all four options for you to choose from. For equity funds, dividend payouts will be less frequent — typically once a year — and at the fund house's discretion. The dividend payout quantum is linked to the size of your investment in a fund. For example, you hold 1,000 units in an equity fund which announced a dividend of ` 0.57 per unit, so your payout was ` 570. Therefore, these dividend payouts won’t augment your income dramatically unless you have a sizeable amount invested in a mutual fund.

ARE DIVIDEND MUTUAL FUNDS RIGHT FOR YOU?

If you are in the growth stage of your life and investing for the long term, you can avoid dividend funds. Also, as someone who has just started investing, the size of your investment would be small and inadequate for providing any useful liquidity via dividends. Therefore, you should avoid dividend funds and stick to growth funds. But if you have surpassed the growth stage, and are primed for retirement or already retired, dividends via debt mutual funds may augment your income in a minor way. However, it would be unwise for small investors to treat dividends as their primary source of income, as such income could be inadequate and infrequent. Dividends should be a secondary, minor source of periodic income.

SO WHAT’S A SMARTER WAY?

A more reliable way to derive periodic liquidity via your mutual funds would be to initiate a Systematic Withdrawal Plan. An SWP would be the opposite of an SIP. The ideal way to use an SWP is to create a mutual fund corpus as per your money goal, and when you reach the liquidation stage ( such as your retirement), you can instruct your AMC to liquidate a fixed amount of a fixed number of units from your fund every month. This way, your immediate liquidity needs are met through the SWP while the rest of your corpus remains invested for growth.

HOW ARE DIVIDEND RETURNS TAXED?

Dividend returns on your mutual fund investment are completely tax- free for you. However, the fund house with whom you have invested pays a dividend distribution tax ( DDT) of 28.84 per cent for your debt funds. From FY 2018- 19, there’s a 10 per cent DDT on dividend from equity MFs.

HOW TO SWITCH IN AND OUT OF DIVIDEND FUNDS

You can switch in and out of dividend funds in two ways.

Firstly, you can switch from dividend payout to dividend reinvestment and vice versa. This is easy and you only need to apply via an application form. Once you submit the form, the switch is verified and brought to action within the next 24 hours. However, switching from dividend to growth option or vice versa in mutual fund parlance is considered as redemption from one scheme and purchase of a second scheme. So, if you want to switch your dividend mutual fund scheme to a growth scheme, then you may have to pay an exit load and capital gains tax on your investment. Thus, it is important to calculate and see whether your dividend earnings make you shell out more in taxes when you decide to switch. Choose growth funds only when your long term capital gains are lower than ` 1 lakh, as this will help you avoid paying tax. Invest in dividend mutual funds only if you want instant gratification from your investment. However, stay invested in growth funds too and balance out your earnings with higher long- term returns. Select the investment type basis your risk appetite and make the most of your money by building an investment folio that promises wealth creation.

The writer is the CEO of BankBazaar. com

A more reliable way to derive periodic liquidity via your mutual funds would be to initiate a Systematic Withdrawal Plan, which is opposite of an SIP.