In an equity fund, it doesn’t make a difference return-wise, whether you choose a dividend or a growth plan. This is because dividends are tax-free in your hands—as well as in your equity schemes’—and so you get the entire amount that your fund distributes. But in a debt fund, your returns will vary, depending on what you choose.
Debt funds impose tax
Depending on the type of debt fund you choose and the tenor for which you aim to stay invested, there are tax implications. Primarily, there are two types of taxes—dividend distribution tax (DDT) and capital gains tax.
All debt funds, except liquid funds, pay a DDT of 13.840% (12.5% tax + 7.5% surcharge + 3% education cess). This is a tax that is paid at the time of dividend distribution and the fund pays it out of the dividend it earmarks for distribution. Therefore, your returns drop if you choose the dividend plan. Liquid funds pay a higher DDT of 28.325%.
Additionally, if you withdraw from your debt fund before a year, you pay a short-term capital gains tax of 10.30%, 20.60% or 30.90%, depending on your income-tax bracket. Long-term capital gains in debt funds are taxed at 10.30%.
Dividend or growth
Despite taxes imposed, we still suggest you give more importance to your financial goals before considering the tax incidences, when investing in a debt fund. If you wish to invest for more than a year, opt for the growth plan, unless you wish to get dividends.
However, if you invest for a period of less than a year—like in a liquid or an ultra short-term fund where you typically invest through a systematic transfer plan and then transfer systematically to equity fund—things are different. Assuming you are in the highest tax bracket, you pay 30.90% short-term capital gains tax every time you switch to an equity fund against 13.840% DDT. Purely from the taxation point of view, the dividend plan works better.
If you choose a dividend plan in a liquid fund or an ultra short-term fund, chances are you’ll get dividends every week or fortnight. Apart from receiving tiny amounts regularly and not knowing what to do with it, you are burdened with account statements that come to you every time your fund declares a dividend. If you keep spending these dividend amounts, the benefits of investment are lost. Opt for dividend reinvestment plan, in this case. Pay less tax, get dividends, which get reinvested automatically.