Mutual funds: Factors you need to consider before investing

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You have several options if you are looking to invest in mutual funds. One such option is to get income from your mutual fund investment or to let the income remain invested until you cash out of the plan. They are known as growth options and dividend options. Growth option reinvests the profits, allowing you to benefit from compounding and is, therefore, more ideal for long-term wealth accumulation. The dividend option distributes the fund’s profit to its investors. This strategy is only appropriate for those desiring a steady stream of income from their mutual fund investments.

Consider the below factors before starting your MF investment journey:

Re-evaluate your objective of pay-outs or re-investments

As an investor, if you are only considering a long-term investment, a growth option will suffice. However, if you’re searching for consistent cash flows, a dividend plan may be preferable. Because dividends in equity funds are uncertain, investors seeking dividends will typically pick debt funds, where regular payouts are more dependable. Many investors also consider dividend plans for tax-saving purposes, as they allow some of the assets to be unlocked during the three-year lock-in period. Your choice must be made solely based on the goal you are pursuing.

Which options fit into your long-term financial plan?

The optimal strategy to begin investing in mutual funds is to start with a specific objective in mind. Once the objective is defined, the following stage is to associate SIPs or mutual fund investments with the objective. When associating a mutual fund with a goal, the first stage is determining if the goal is short-term, medium-term, or long-term.

Typically, debt funds are associated with medium-term objectives, while equity funds are related to long-term objectives. When funds are assigned to objectives, the first objective is to generate wealth through reinvestment, which occurs more frequently in growth funds. Dividends diminish your NAV, hence reducing your long-term wealth growth capacity.

Tax implications

Taxation is one of the primary distinctions between dividend and growth investing.

Dividend option: Dividend distribution tax (DDT) on dividends declared by mutual funds was removed in Budget 2020. Instead of that, it has made dividends taxed at the investor’s income tax rate. For example, someone in the 30% tax bracket will pay tax at that rate on mutual fund dividends (debt or equity). This will take effect in fiscal years 2020-21.

Growth option: If you choose the growth option, the following tax implications may emerge as a result of capital gains. If you hold an equity mutual fund for more than a year, the profits are tax-free and are referred to as long-term capital gain. If the investment is kept for less than a year, it is referred to as a short-term capital gain and is taxed at 15%.

If you keep non-equity funds for more than three years, the earnings are classified as long-term capital gain; otherwise, they are classified as short-term capital gain (taxed at a higher rate)

Endnote

It is prudent to keep in mind that the dividend alternative is preferable if you are an investor in need of monthly income. Your investments will provide you with some liquidity since a portion of the money you invest will flow back to you regularly. If your goal is to allow your money to expand over time, select the growth option. Compounding occurs in the growth choice because the gains on your investment are reinvested; this is not the case in the dividend option.