How to Choose between Growth or Dividend Reinvestment while Investing in Arbitrage Fund:?

Arbitrage mutual funds are good investment option for short term, especially for someone in higher tax bracket. The reason being their pre-tax return is comparable to the bank fixed deposits but is tax free if invested for more than 1 year and taxed at 15.45% if redeemed before 1 year of investment. interest on FDs are taxed at marginal tax rates.

While investing in mutual funds an investor has to choose between two options:

  1. Growth
  2. Dividend (Reinvestment/ Payout)

In this post we find out which option – Growth Vs Dividend should you choose while investing in Arbitrage Mutual Funds. Here is an example.

We assume that Amit wants to invest Rs 1 Lakh in IDFC Arbitrage Fund (Direct Plan). He is confused between Growth or Dividend Reinvestment – as which would be more beneficial for him. We take two cases :

  1. when the investment horizon is less than 1 year and
  2. when it’s more than 1 year

Also Read: Use SWP in Debt Funds to generate Regular Income

Case 1: Investment for less than 1 Year

Amount to be invested: Rs 1 Lakh

Investment Date: April 1, 2015

Redemption Date: November 30, 2015

Let’s see how the returns change for Growth and Dividend Reinvestment options:

Growth Option:

NAV as on April 1 = Rs 18.497

Units Purchased =  1,00,000/ 18.497 =  5,406.28

NAV as on November 30 = Rs 19.3706

Redemption Amount = 5,406.28 X 19.3706 =  Rs 104,722.93

Capital Gains = 104,722.93 – 1,00,000 = Rs 4,722.93

Since the investment was for less than 1 year, this is Short term capital gains. The gain would be taxed at 15.45%.

Also Read: How are Mutual Funds Taxed?

Tax to be paid = 15.45% X 4,722.93 = Rs 729.69

Net gains after tax = 4,722.93 – 729.69 = Rs 3,993.24

Total amount after tax = 1,00,000 + 3,993.24 = Rs 1,03,993.24

Dividend Reinvestment Option:

NAV as on April 1 = Rs 12.7146

Units Purchased =  1,00,000/ 12.7146 =  7,864.97

In case of dividend reinvestment, fresh units are purchased every time dividend is declared by the fund. The gain happens in terms of increase of number of units. The fund has declared dividend every month as shown in the table below:

Mutual Fund Units accumulation under Dividend Reinvestment

Mutual Fund Units accumulation under Dividend Reinvestment

By November 30, the numbers of units increase from 7,864.97 to 8,165.68.

NAV as on November 30 = Rs 12.8246

Redemption Amount = 8,165.68 X 12.8246 = Rs 1,04,721.52

Also Read: Why Investing in Mutual Fund NFOs is Bad Idea?

Gain = 1,04,721.52 – 1,00,000 = Rs 4,721.52 All this is not capital gains but due to dividend. We would break this into capital gains and dividend gains.

Capital gains for each purchase of dividend reinvestment would be calculated separately as in the table below.

Capital Gains Calculation for Dividend Reinvestment in Arbitrage Mutual Fund for less than 1 Year

Capital Gains Calculation for Dividend Reinvestment in Arbitrage Mutual Fund for less than 1 Year

The total Capital gains = Rs 884.06 (Short Term)

Tax on capital gains = 15.45% X 884.06 = Rs 136.59

Total amount after tax = 1,04,721.52 – 136.59 = Rs 1,04,584.94

As can be seen Dividend Reinvestment Option is better than Growth option for Arbitrage funds if the investment duration is less than 1 year.

Also Read: How to invest in DIRECT Plan of Mutual Funds?

Case 2: Investment duration is more than 1 Year

Amount to be invested: Rs 1 Lakh

Investment Date: April 1, 2015

Redemption Date: April 4, 2016

Let’s see how the returns change for Growth and Dividend Reinvestment options:

Growth Option:

NAV as on April 1, 2015 = Rs 18.497

Units Purchased =  1,00,000/ 18.497 =  5,406.28

NAV as on April 4, 2016 = Rs 19.8352

Redemption Amount = 5,406.28 X 19.8352 =  Rs 1,07,234.69

Capital Gains = 1,07,234.69 – 1,00,000 = Rs 7,234.69

Since the investment was for more than 1 year, this is Long term capital gains and hence tax free.

Tax to be paid = 0

Total amount after tax = Rs 1,07,234.69

Also Read: Where to Park Money for Very Short Term [less than 6 Months]?

Dividend Reinvestment Option:

NAV as on April 1 = Rs 12.7146

Units Purchased =  1,00,000/ 12.7146 =  7,864.97

Calculating the same way as we did in the case above – By April 4, 2016 the numbers of units increase from 7,864.97 to 8280.24

NAV as on April 4, 2016 = Rs 12.9504

Redemption Amount = 8280.24 X 12.9504= Rs 1,07,232.51

Gain = 1,07,232.51 – 1,00,000 = Rs 7,232.51. This has gains from short term, long term capital gains and gains due to dividend. We would break this into capital gains and dividend gains.

Capital Gains Calculation for Dividend Reinvestment in Arbitrage Mutual Fund

Capital Gains Calculation for Dividend Reinvestment in Arbitrage Mutual Fund

As seen in the table there is Rs 1,854.56 Long Term capital gains which are tax free.  Rs 62.98 is Short Term Capital Gains which would be taxed at 15.45%.

Tax on Short Term Capital Gains = 15.45% X 62.98 = Rs 9.73

Total amount after tax = 1,07,232.51 – 9.73 = Rs 1,07,222.78

As can be seen Growth option is marginally better than Dividend reinvestment option for Arbitrage funds if the investment duration is more than 1 year.

The point to note is as the duration of investment increases further Growth option would turn out to be more beneficial.

Also Read: SIP Vs. Lumpsum – Which is the Best way to Invest in Mutual Fund?

Recommendation:

To summarize Dividend reinvestment in Arbitrage Mutual Fund option is better than growth in case the investment duration is less than 1 year. For more than 1 year, growth option is better.

This is true for all tax brackets as dividend paid on arbitrage fund is tax free.

In case of debt mutual funds, the calculation would happen on similar lines but there is dividend distribution tax of 28.84% (25% + 12% Surcharge + 3% Cess). So Dividend reinvestment is better only for people in 30% tax bracket and investment duration of less than 3 years. For all others Growth option is the right option (More details in another post…).

As you can see the tax computation of dividend reinvestment is complicated, so if you want to keep your life simple choose growth option.

2 thoughts on “How to Choose between Growth or Dividend Reinvestment while Investing in Arbitrage Fund:?

  1. Dear Amit,

    Pl share your views on – dividend payout option as I am Sr citizens and want to invest in tax free options.
    Thanks
    Shrikant

    • The problem with dividend payout is – it might not be regular and even if it is paid at fixed period – the amount might vary to large extent. In case you are in 30% tax slab – you can invest in tax free bonds from secondary market with yield of more than 7%. The other tax efficient option is to invest in debt funds and start withdrawing systematically after 3 years. In that case you will incur long term capital gains and be taxed at 20% after indexation. In this case, the tax paid would be very nominal. I had earlier written about 13 Investments to Generate Regular Income which might be helpful.

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