Growth Plan vs. Dividend Reinvestment Plan of Mutual Funds

Dec 30, 20248 min read

When investing in mutual funds, one of the critical decisions an investor faces is choosing between a growth plan and a dividend reinvestment plan. While these two options may seem similar on the surface, they differ significantly in their approach to handling dividends and the resulting implications for investment growth and taxation.

The growth plan is a straightforward option where the mutual fund scheme reinvests all its earnings, including dividends, back into the fund. This means that dividends are not distributed to investors but are instead used to purchase additional securities on behalf of the fund, thereby increasing the Net Asset Value (NAV) and facilitating the growth of your investment corpus.

On the other hand, the dividend reinvestment plan, also known as the Reinvestment of Income Distribution cum Capital Withdrawal (IDCW) plan, offers a more granular approach. In this plan, any dividends declared by the mutual fund scheme are automatically reinvested by purchasing additional units of the same fund on behalf of the investor. This process allows for compounding of returns as your investment grows through the acquisition of new units.

While both options aim to facilitate long-term wealth creation, they diverge in terms of their mechanics, taxation implications, and suitability for different investor profiles. In this article, we will delve into the intricacies of growth plans and dividend reinvestment plans to help you determine which option aligns better with your investment goals, risk appetite, and tax considerations as an investor.

Note: Whether you opt for a mutual fund offering a dividend reinvestment option or a growth option, you're essentially choosing to forego receiving regular dividend payouts. Instead, you're entrusting the fund to utilize that money to expand your holdings over time by reinvesting on your behalf.

What is a Dividend Reinvestment Plan?

In a dividend reinvestment Plan, when a mutual fund declares dividends, you don't receive them as cash. Instead, they're automatically reinvested back into the same fund at its current Net Asset Value (NAV) after the dividend declaration. This means you get more units of the fund, which increases your investment capital. However, it's essential to note that the NAV of the fund drops by the amount of the dividend distributed, reflecting the reinvestment.

How does a dividend Reinvestment Plan Work?

Let's assume Investor A invests in XYZ Mutual Fund, which offers a dividend reinvestment option. They own 1,000 units with a NAV of ₹ 50 per unit on the ex-dividend date (the date after which new investors won't receive the dividend).

dividend Declaration:

XYZ Mutual Fund declares a dividend of ₹ 5 per unit. Reinvestment under Dividend Reinvestment Plan:

Instead of receiving ₹ 5,000 (1000 units * ₹ 5) in cash, the fund automatically reinvests it into additional units of XYZ Mutual Fund.
The number of additional units purchased is calculated the same way: ₹ 5,000 (dividend amount) / ₹ 50 (NAV) = 100 units.

NAV Adjustment:

To reflect the reduced overall value after dividend distribution, the NAV of the fund decreases after the dividend is paid out.
Let's say the new NAV becomes ₹ 45 per unit (original NAV - dividend per unit).

Dividend Reinvestment:

Investor A's 1,000 units are now worth ₹ 45,000 (1,000 units * ₹ 45 NAV).
The fund uses the dividend amount (₹ 5,000) to purchase additional units at the post-dividend NAV (₹ 45).
This translates to 111.11 units (₹ 5,000 / ₹ 45 NAV). Due to rounding, most dividend reinvestment plans might purchase the closest whole number of units (likely 111 in this case).

Investor A's New Position:

Investor A holds a total of 1,111 units (1,000 original units + 111 reinvested units).
The total value of their investment remains ₹ 50,000 (1,111 units * ₹ 45 NAV).

Key Points:

The dividend payout reduces the overall value of the fund, reflected in the decrease in NAV.
The fund reinvests the dividend at the post-dividend NAV, purchasing additional units.
The total investment value of an investor with a dividend reinvestment option might remain the same despite the NAV drop because the increase in units offsets the decrease in NAV per unit.

Therefore, the total value of Investor A is 1,111 units * 45 = ₹ 50,000

Thus only the number of units of Investor A have increased, while the investment value has remained the same.

However, this plan may not be suitable to all investors, as a 10% TDS (Tax deduction at source) is applicable on dividends distributed my Mutual Funds if the value exceeds ₹5000, regardless of whether the fund reinvests the dividends or not. Therefore, your investment value might go down in a dividend reinvestment plan as compared to a dividend growth plan on dividend distribution.

What is a dividend Growth Plan?

On the other hand, a Growth Plan is a straightforward option where the mutual fund scheme reinvests all its earnings, including dividends, back into the scheme. This means that any dividends declared are not distributed to investors but are instead used to purchase additional units within the fund, thereby increasing the Net Asset Value (NAV). The Growth Plan follows a simple yet effective approach to wealth accumulation, allowing your investment to grow through the compounding effect of reinvested earnings.

Under the Growth Plan, the mutual fund scheme does not physically pay out dividends to investors Instead, when the fund generates returns through its investments, these returns are retained within the scheme and utilized to purchase additional units. Consequently, the NAV of the scheme rises, reflecting the growth in the value of your investment.

How Does a dividend Growth Plan Work?

In a growth option, when dividends are declared, they are not used to directly purchase additional units for each investor. This is a key distinction from a dividend reinvestment option where the dividends are indeed used to buy extra units for each participant.

What happens in a growth option:

The mutual fund receives the total dividend amount from all investors (dividend per unit multiplied by total outstanding units).
This money is pooled together and used by the fund manager to purchase additional securities for the entire fund.

Impact on NAV:

These newly acquired securities increase the overall value of the fund's holdings.
The NAV of the growth option then gradually increases to reflect this rise in the underlying asset value.

Investor Benefit:

Existing investors don't receive new units directly due to dividend reinvestment.
However, they benefit from the rising NAV, which applies to their existing number of units.
The value of their investment grows as the NAV increases (existing units multiplied by new NAV).
When the fund's overall value increases due to new security purchases, the NAV reflects this proportionally, without affecting the value of existing units.

For Example: Imagine a mutual fund has 100 units outstanding and a starting NAV of ₹10. The total value of the fund is ₹1000 (100 units * ₹10 NAV).

If the fund declares a dividend of ₹1 per unit, it collects a total of ₹100 (100 units * ₹1 dividend).
This ₹100 is used to buy additional securities, increasing the fund's overall value to, say, ₹1100.
The NAV then adjusts to reflect this new value. It might become ₹11 (₹1100 total value / 100 units).

Crucially, the existing units (100) still represent the same ownership stake in the fund, but their value has increased due to the rise in NAV.

This is the same concept that applies to your investment in a dividend growth option. For instance,

Investor A owns 1,000 units of XYZ Mutual Fund, a dividend growth option, with a NAV of ₹50 per unit on the record date (the date on which investors are recorded to receive the dividend).
XYZ Mutual Fund declares a dividend of ₹5 per unit.
The fund retains the total dividend amount of ₹5,000 (₹5 x 1,000 units).

NAV:

The NAV of the Dividend Growth Option doesn't immediately decrease due to the dividend.
The fund manager uses the total dividend received from all investors to purchase additional securities for the fund. Increasing the overall value of the fund by the entire dividend amount received from all units in the fund.

Gradual NAV Increase:

These additional securities may increase the overall value of the fund's holdings over time.
As the value of the underlying holdings goes up, the NAV of the dividend growth option may gradually rise in the future.

Investor A's Benefit:

Investor A doesn't see an immediate rise in units like with a dividend reinvestment option.
However, they potentially benefit from the future increase in NAV due to the reinvestment of dividends and any capital appreciation of the securities.
The total value of their investment becomes a function of the future NAV (1000 units * new NAV).

Key Points:

dividend growth option automatically reinvest dividends, offering a compounding effect.
There's no direct credit of additional units due to dividend reinvestment.
The benefit comes from the potential rise in NAV over time.

Unlike in a dividend reinvestment plan, TDS (Tax deduction at source) won't be applied on the dividend growth plan. Thereby increasing the amount reinvested via the growth plan in comparison to the dividend reinvestment plan.

Taxation of dividend Reinvestment Plan and dividend Growth Plan

According to the latest income tax regulations, any dividends received from Mutual Fund schemes after April 1, 2020, are subject to taxation based on the investor's applicable tax slab. Even if you choose to reinvest dividends in the same mutual fund scheme, the income tax rules offer no exemption. Consequently, despite not physically receiving the dividend in your bank account, you're still required to pay tax on those dividends since they're treated as part of your income by the tax authorities.

For instance, if you find yourself in the 30% tax bracket, you'll be liable to pay 30% tax on the dividends declared in the dividend Reinvestment Plan during a financial year. This taxation effectively reduces the returns generated from Mutual Funds.

Additionally, a 10% Tax Deducted at Source (TDS) is applicable on dividends distributed by Mutual Fund schemes if the dividend amount exceeds Rs. 5,000. In the scenario mentioned above, this means the reinvested amount will be reduced due to the TDS imposed on mutual fund dividends. Consequently, the final value of investments will also be diminished.

Considering the impact of both dividend taxation and TDS, the total investment value tends to be lower in the dividend reinvestment plan compared to the Growth Plan.

However, there is a specific scenario where the returns from the dividend Reinvestment Plan equal those of the Growth Plan. This occurs when the declared dividend falls below Rs. 5,000, and your total taxable income remains below Rs. 5 lakh per annum. In such cases, no TDS is applicable, and you won't have to pay any tax on your dividend. As a result, the reinvested amount in the dividend Reinvestment plan remains on par with the Growth Plan.