• Part 1: What are mutual funds? Where do they invest?
• Part 2: Mutual funds, demystified
• Part 3: 6 advantages of investing in a mutual fund
• Part 4: The risks of investing in a mutual fund

When you invest, you can look at the investment from two perspectives: to generate a regular periodic return or to invest for a long term, without bothering about the intermediate returns. Mutual funds are a great avenue for achieving either end.

You can either choose to invest in the 'dividend' option or a 'growth' option to achieve your objectives. 

When a mutual fund invests money on your behalf and makes gains on the same, it can either return the gains to you or keep the gains in the fund on your behalf. You can use either of these options based on your requirements. However, be careful that you know the tax treatment!

Dividend option:

If you are someone who requires money on a periodic basis from your investments, then you should choose the dividend option. This means that the fund will periodically (quarterly or mostly, annually) return some of its gains to you. Note that the fund is under no obligation to declare a certain rate of dividend.

The amount of dividend that it pays out depends on the gains that it has made, and here too, the fund manager/the asset management company can decide to return only part of the gains. A fund cannot dip into its corpus to pay dividend.

For example, assume the fund collects Rs 10 from you and at the end of one year, the fund value has risen to Rs 11. The fund can declare a dividend of any amount up to Re 1. It cannot go beyond Re 1 because then it will have to dip into its original corpus, which it is not allowed to do.

Assume that your fund declares a dividend of Re 0.8. When a non-equity oriented mutual fund declares dividend, it pays a tax of 15% (+10% surcharge and 3% cess, totalling to 15%*1.1*1.03=16.995%) on the dividend amount. Hence, in this example, the fund will need to pay Rs 0.14 (Rs. 0.8*16.995%) as dividend distribution tax.

However, once this tax is paid, the dividend received is tax free in the hands of the investor. Recently, this dividend distribution tax has been increased to 25% in case of liquid funds: the calculations remain similar.

The value of the fund (and your investment) will fall from Rs 11 to Rs 10.06 (i.e. Rs 11 � Rs 0.8 � Rs 0.14). This is an important point because many people do not realize that dividends reduce the value of the investment and also because dividend is considered as tax free. Clearly, your money is refunded to you and also the same goes from your investment to pay the dividend distribution tax.

However, if an equity fund were to declare a dividend, there is no dividend distribution tax. Hence, when a mutual fund declares Rs 0.8 as dividend, you receive Rs 0.8 and the NAV falls to Rs 10.2.

Note that in this option, you face 'reinvestment risk' -- you need to plan where you will invest the dividend amount.

Growth option:

If you do not want the investment back on a regular basis but would rather wait till the end of your planning horizon for the investment, then you should choose the 'growth option.' This option means that the gains that the fund makes are retained in the fund and are invested on your behalf.

Taking the earlier example, the fund will reflect as Rs 11 as your balance in the fund at the end of the year. However, you will receive nothing from the mutual fund as current income. Note that because nothing is paid to you, you do not need to pay anything to the government as taxes.

If you sell a mutual fund with 'growth' option, you will have to pay the government capital gains taxes. If you hold the fund for less than a year, you will pay short term capital gains tax at the marginal rate of taxation (30%+10% surcharge+3% cess).

However, if you hold the mutual fund for more than a year, you pay the concessional long-term capital gains tax. If you are holding an equity mutual fund (any fund that invests greater than 65% of its corpus in equities), then the capital gains tax is nil. In case of debt funds, you need to pay 10% or 20% indexed gains.

Dividend reinvestment option:

There exists a provision in many mutual fund forms which asks you whether you want your dividend reinvested. This was a good provision when there was no tax on dividends and the long term capital gains tax was not zero.

Then, it was better for you to have shown the income as dividend and reinvest it: that way you avoided paying long term capital gains tax.

However, now the situation is reversed -- we have zero long-term capital gains tax and there is tax on dividends received. Hence, this option does not make sense under any circumstance -- though some fund houses still carry it as a legacy option.

Conclusion

If you have a horizon of greater than a year, then the growth option makes sense for you. Similarly, if you do not have a need for a periodic flow of income, growth option is better for you.

Remember two things from this article: a) dividend is your own money back to you and it may not be tax-free, and b) never choose the dividend reinvestment option.

Next, we will look at the various ways of investing in a mutual fund.

• See tomorrow: What is SIP? How to invest in an SIP

The author is Director, PARK Financial Advisors Pvt. Ltd., Mumbai. He is an IIM-Ahmedabad almunus. He can be contacted at tilotia.akhilesh@parkfa.com