1. What does dividend option mean in a mutual fund?
A mutual fund scheme be it equity or debt can declare dividend for its unitholders from realised profits in its portfolio. Realised profits are the gains made from instruments by selling them at a price higher than what they were purchased for or when the securities held in the scheme receive dividend or interest (in the case of debt funds) from the instruments they hold. Unrealised profits from the securities/instruments held in the portfolio cannot be used to pay dividends.
Dividends in mutual fund schemes excite investors. In fact, many of them apply just before the declaration date to earn that dividend. Retirees prefer the dividend option as it gives them intermittent cash flows.
2. How does dividend payment work? What happens to the NAV once the dividend is paid?
So assume you have invested in a fund at the NAV of Rs 14 and opted for dividend option. The scheme performs and after appreciation, the NAV reaches Rs 16. The fund house may decide to pay out Rs 2 as dividend. So you receive Rs 2 and simultaneously the NAV will fall back to Rs 14. Schemes of mutual funds can decide their own frequency to pay a dividend. This could be daily, weekly, monthly, quarterly or annual or just when they have surplus money to declare a dividend. The dividend is not assured by a scheme and there is no guarantee of its payment, but most of them endeavor to pay dividend and stick to their respective mandate. For example, several liquid and ultra short term funds endeavor to pay a daily dividend, some hybrid or balanced funds pay monthly dividends while some equity funds pay quarterly and annual dividends. However, investors need to keep in mind, dividends are not certain and the amount is not fixed.
3. How are dividends taxed in the hands of the investor?
Dividends received from all mutual fund schemes be it equity, debt or hybrid is tax-free in the hands of the investors. However, in the case of debt funds, the fund house pays a dividend distribution tax of 28.84% which includes surcharge and cess. In an equity mutual fund, there is no dividend distribution tax.
4. Should investorsgoingfor SIPs in equity funds opt for the dividend option?
For those looking to build wealth over the long term through equity mutual fund systematic investment plan (SIP), it is better to go with growth option. This is because the compounding benefit is lost when dividend is paid, unless the amount is invested immediately in a higher than equity yielding asset. For those needing regular income from equity or balanced funds, financial planners advocate systematic withdrawal plan as a better tool for regular flows compared to dividends.
5. What dividend option should investors use while using a debt fund?
For those in the highest tax bracket investing for a period less than three years, could opt for the daily dividend option in liquid / ultra-short-term funds as the dividend distribution tax is 28.84% compared to their individual tax slab of 30.9%.