Monday, February 26, 2007

A taxing question – Which Option would you opt for?

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

A taxing question – Which Option would you opt for?

The choices are endless. You decided what type of fund to invest in and that was a mammoth task in itself. But it did not stop there. An array of questions were then hurled at you. "Would you choose the dividend option or the growth option? "Would you opt for a dividend payout or dividend reinvestment?" Don't get bogged down by these innumerable questions.

An illustration will aid you in finding answers to these questions. Let us say you own 100 units of a Mutual Fund whose current NAV is 20. Your investment value is Rs 2,000 (100 x 20). Now, the scheme declares a dividend of 10%. It is pertinent to note that dividend is always a percentage of the face value. Face value is the price of one unit of a fund and is Rs 10. So 10% of face value would be Re 1 per unit. For the bonus plan, the scheme declares a bonus of 1:10. This means an additional unit for every 10 units held.

This is what will happen under the various options.

In the growth option the fund reinvests the money it would otherwise pay out in the form of a dividend. This money increases the net asset value (NAV) of the mutual fund. That is why the NAV of the growth option is higher than that of the dividend option. You can realize a higher capital gain on the same number of units you originally purchased. The onus of booking profits (by way of redemption) lies solely on you. Selling of units results in a decrease in the number of units held by you with the NAV remaining unchanged.

In the dividend payout option, you will get Rs 100 as dividend while the NAV falls to Rs 19. Effectively, the dividend received from the fund house is set-off by a reduction in the fund’s NAV. Moreover, your investment value falls to Rs. 1900 (unlike all other options where the investment value remains unchanged).

In the dividend re-investment option, the dividend of R.100 is not paid to you. Instead, 5.2631 more units are purchased at the revised NAV of Rs.19. Usually, no entry load is charged. Consequently, you have more units at your disposal every time a dividend is declared, but the NAV witnesses a depreciation.

The bonus option is similar to dividend re-investment, except that the fund announces the bonus ratio instead of dividend. You get 10 more units, because of which the NAV falls to Rs 18.1818. (Earlier long-term capital gains were taxed at a lower rate than dividends. This option is no longer offered since dividends do not attract tax.)
Clearly, there is very little differentiating the various options in terms of returns. If you are keen on receiving an income at various intervals, go in for the dividend option. But the dividend is not guaranteed. In case of a downturn in markets, you would have returns to show for by way of dividends received earlier. Conversely, in case of a long-term investment (which is the norm for equity investments), the growth option enables you to enjoy the benefits of compounding. If you are looking at a long-term investment and are not interested in money being given to you at various intervals, the growth option is meant for you. Choose between the various options based solely on your need for liquidity and tax planning.

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