Some people like the thought of booking regular profits on their investments in mutual funds. As these investors do not seek regular income from such MF investments, they tend to reinvest profits gained back into the scheme. Such reinvestment is usually done via the dividend reinvestment plan option that is provided by varied mutual funds.
How does dividend reinvestment plan work?
It is a known fact that the profits realized by mutual funds are shared in the form of regular dividends. Investors who have chosen the dividend plan will get such dividends. In the dividend reinvestment plan, the regular dividends do not get transferred to the investors in monetary form. The dividends are used for purchase of additional units of the mutual fund scheme. This means that investors who have selected the dividend reinvestment plan would observe a periodical increase in the total number of units held by them in that scheme.
How does dividend reinvestment plan help investors earn extra profits?
From a pragmatic viewpoint, the dividend reinvestment plan does not make good investment sense. It may be noted that under growth option of a mutual fund scheme the value of investment tends to be the same as the dividend reinvestment plan, after dividends are reinvested in case of dividend reinvestment plan.
Increase in the total number of units is the only distinction under the reinvestment plan. The net asset value or the NAV gets adjusted according to the dividend amount that is reinvested. It may be noted that the fund NAV under the reinvestment plan drops almost simultaneously with the declaration of the dividend.
The above discussed facts will make you think about reasons why investors would go for the dividend reinvestment option when their investments are in a balanced or equity scheme. The main aim of such mutual fund schemes is to offer the reward of capital appreciation in the long term. However, long term capital gains do not have any kind of taxation after a period of 1 year.
The dividend reinvestment plan also does not make any practical sense when it comes to investments of over 3 years in debt fund schemes. It may be noted that long-term capital gains tax for debt-based mutual fund investments that are held for more than 3 years would be 20 percent along with indexation gain. The cost of purchase adjusted to inflation assists investors in considerably reducing the tax liability.
The option of dividend reinvestment tends to make sense when investors are putting their money in liquid funds which have very short horizons and the associated dividends get paid per day or per week.
The dividend reinvestment plan may be a good option for those who are investing in debt fund schemes with a horizon of less than 3 years, particularly if you fall under the higher income taxation bracket. Investors who are in the thirty percent tax slab are likely to receive slightly more ( around 3 to 4 percentage points) with the dividend reinvestment option.
Even though dividends received by the investors do not get taxed, a dividend distribution tax of nearly 29 percent is paid by the mutual fund on the dividends that are declared. Thus, it does not make any practical sense for investors who fall under the 10 and 20 percent tax bracket to go for the dividend reinvestment plan. Such investors can earn more profits after tax under growth mutual funds. If their debt-based mutual funds are sold before 3 years, then the short-term capital gains gets added to the investors’ income and then taxed as per their respective income tax slab.