Best mutual funds? Let your taxes decide

Mutual funds offer three options to an investor: Dividend, Dividend Reinvestment and Growth. Last time, we considered the pros and cons of choosing the Dividend option.

To recap

Dividend money not utilized vegetates in the bank, thereby diluting the rate of return. On the other hand, if it has to be re-invested in equity --- then why take it out in the first place? And lastly, all funds pay dividends at their whim and not your fancy. Instead, take matters in your own hands, opt for the growth option and withdraw the non-taxable long-term gains as dividend.

This time lets see what the Dividend Reinvestment option is all about.

Dividend v/s Dividend Reinvestment

Tax policy and tax policy alone should dictate the choice of Dividend Reinvestment option. There is simply no other criterion.

Let's see why. Again, let's take the example of Franklin India Prima, a scheme that has been in existence, in one form or another, since November 1993. At the time of writing this, the NAV of Prima Growth option is Rs 155.10 whereas that of the Dividend option is Rs 49.39. Notice that there is no separate NAV declared for the Dividend Reinvestment option. Why is this?

The reason is simple. As far as NAV is concerned, there is no difference between the Dividend option and the Dividend Reinvestment option. In other words, the NAV of the Dividend option of Prima would also apply to the Dividend Reinvestment option.

How does the Dividend Reinvestment option work?

This is because, under the Reinvestment option, instead of actually physically receiving the dividend in your bank, the Mutual Fund itself ploughs it back at source by allotting additional units in the scheme to the investor.

In fact, you could have done the same. . . after having received the dividend; you could have cut a cheque to invest the dividend amount into the scheme. Since this is done at source, the only difference between the Dividend option and the Reinvestment option is the time saved in the latter. Of course, there is no entry load imposed but that's not the point here.

The problem with receiving the money and then investing it is that often times, the money lies in the bank but you just haven't got down to actually investing it. Each day that passes dilutes the return on your investment.

The other problem is our innate psychology. . . just then if the market is volatile, you may defer the decision of committing money and again on an overall perspective, the return suffers. With dividend reinvestment, there is a kind of enforced discipline. . . since the MF is doing it on your behalf, you take away the discretion element from the equation. Then isn't this the best option to choose?

Again, not so fast. There is the tax angle to consider.

As the tax law stands today, in the absence of dividend distribution tax on equity-based funds and no long-term capital gains tax, there is absolutely no difference between the Growth option and the Dividend Reinvestment option. Both will yield the same market value of your assets.

That is as of today.

However, say the government were to re-impose the dividend distribution tax (currently only non equity oriented funds suffer the 14.025% dividend distribution tax), then what would happen is that each time dividend is declared, 14.025% lesser would get reinvested. Over time, this difference would get significant as compared to the Growth option.

However, on the other hand, say long-term capital gains tax is reintroduced. In this case, Dividend Reinvestment would prove superior to the Growth option. This happens as, eventually, when the investment is sold, the dividend represents the cost of the units and hence capital gain incidence is reduced.

Admittedly, all this can be a little confusing. . . therefore, let's understand this with the help of an example.

Consider the following table. This is the investment in the growth option. The first investment is made on 1st of January 2006. 10000 units are purchased @ Rs 10 each for a total outlay of Rs 1,00,000. The scheme performs well and after one year on 1st of January, 2007, the NAV of the scheme stands at Rs 13.

Now, if the investment is sold, the investor would earn a capital gain of Rs 30,000 and @10%, the tax would work out to Rs 3,000. (Remember, as of now, there is no capital gains tax but we are assuming it to be imposed).

Now, lets take the same numbers and see how they work out with the Dividend Reinvestment option.

As on January 1st, 2007, there is no difference in Dividend Reinvestment and the Growth option. Then, the MF declares its first dividend of 20% or Rs 2 per unit. The ex-dividend NAV stands at Rs 11 (Rs. 13 – Rs 2). The investor will receive Rs 20,000 as dividend (10,000 units @ Rs 2 per unit). This Rs 20,000 gets reinvested at the ex-dividend NAV of Rs 11 thereby yielding 1818.182 units. Note 1818.182 x 11 = 20,000. The following table encapsulates this information.

Now, see how the capital gains work out. The sale value of 11818.182 units @ Rs 11 is Rs 1,30,000, the same as that of the Growth option. However, there is a difference as far as cost is concerned. The cost of the original units stands at Rs 1,00,000.

However, the cost of the additional units on account of the dividend reinvested is Rs 20,000. The following table encapsulates this data.

The capital gain tax works out to Rs 1,000 significantly lower than the Rs 3,000 that we arrived at for the Growth option. This example considers an investment of Rs 1,00,000 over one year. Higher outlays over longer periods of time will only amplify the advantage of the Dividend Reinvestment option.

To sum up

So now we understand --- the battle of Dividend Reinvestment v/s Growth is decided only by the current tax policy. As of now, both are equal, there is no winner or loser. If tomorrow distribution tax is imposed, Growth will be the clear winner. If on the other hand, long-term capital gains tax is imposed, Growth can't touch Dividend Reinvestment.

Last Point

We have considered long-term capital gains tax. But what about short-term? Readers would know that even equity funds suffer a 10% tax on redemptions before one year. Under specific circumstances, this factor may come into play.

Notice in the above example, actually, the units representing dividend reinvested are sold within a day. I did not want to compromise simplicity for accuracy. Therefore, for ease of understanding and to keep things uncomplicated, I have used the long-term gains. However, in practical life, the short-term tax rate would apply.

To put it differently, consider an investment in the Dividend Reinvestment option with a five-year horizon. Any dividends reinvested in the last year may be taxable as short-term capital gains if a period of 12 months doesn't elapse between the sale date and the date of reinvestment. Take care of this pitfall.

The writer is Director of A N Shanbhag NR Group, a Mumbai based tax and investment advisory firm. He may be contacted at sandeep.shanbhag@gmail.com