When investing in mutual funds, you will usually find multiple investment options tailored to different financial goals. Two of the most popular choices among these for long-term investors are he growth option and dividend reinvestment option.

While they may seem similar, each comes with unique advantages and tax implications that will affect your returns. See these two options in more detail to decide which one aligns with your financial strategy.

• Growth option reinvests earnings, maximising long-term compounding.
• Dividend reinvestment increases units but can trigger immediate taxation.
• Growth option is tax-efficient, as you are taxed only at redemption.
• Choose based on your financial goals and tax considerations.

Growth option in mutual funds is designed for investors who want their money to remain invested for the long run. In this option, profits earned by the mutual fund in the form of dividends or capital gains are automatically reinvested into the fund. Investors don’t receive periodic payouts but benefit from the power of compounding, where the returns themselves generate more returns over time.

With the growth option, the Net Asset Value (NAV) of the fund steadily increases as the profits accumulate. The number of units that the investor holds remains the same, but their value rises, leading to long-term wealth accumulation.

In the dividend reinvestment option, mutual fund investors receive dividends as part of the fund’s earnings. However, instead of receiving these dividends in cash, the money is used to purchase additional units of the same fund. This means that the investor’s unit count increases over time as more units are added with each dividend payout.

Under this option, the number of units grows and the NAV decreases each time a dividend is paid, as it gets adjusted for the payout. This option allows investors to grow their investment through both increased units and capital appreciation, but it could be more tax inefficient when compared to the growth option.

When deciding between the growth option and the dividend reinvestment option, several factors come into play, like your financial goals, risk tolerance, and tax planning. See the key differences between the two options in the table below:

Consider an example to see how the growth and dividend reinvestment options work in practice. Suppose that you invest Rs. 60,000 in a mutual fund with an initial NAV of Rs. 12 per unit. This gives you 5,000 units of the fund. Now, after one year, the NAV rises to Rs. 18 per unit, and the fund declares a dividend of Rs. 2 per unit.

Dividend reinvestment option

In the dividend reinvestment scenario, you will get a dividend of Rs. 10,000 (5,000 units × Rs. 2 dividend per unit). But instead of receiving this amount in cash, the dividend is used to buy more units of the fund. At the adjusted NAV of Rs. 16 (due to the dividend payout), you will get an additional 625 units (Rs. 10,000 / Rs. 16 per unit). You now hold 5,625 units in total.

However, the NAV has reduced to Rs. 16 per unit, so the total value of the investment is Rs. 90,000 (5,625 units × Rs. 16 per unit).

Growth option

In the growth option, there is no dividend payout, so the NAV remains at Rs. 18 per unit. Your 5,000 units are now worth Rs. 90,000 (5,000 units × Rs. 18 per unit). There are no additional units in this case, but the NAV has risen to reflect the reinvested profits.

At first glance, the total value looks identical in both scenarios. However, taxation can significantly affect your overall returns.

In the dividend reinvestment option, even though the dividend is reinvested to purchase more units, it is still considered taxable income in the year in which you declare it. If you are in the 30% tax bracket, you would owe Rs. 3,000 in taxes (30% of Rs. 10,000). This reduces the final investment value by the same amount.

In contrast, under the growth option, you did not receive any dividends, so there is no tax liability until you decide to sell or redeem the units. You will only pay capital gains tax, which is usually more favourable for long-term investments.

Both the growth and dividend reinvestment options offer unique benefits depending on your financial needs and goals. If you’re looking for long-term capital appreciation and wish to avoid immediate tax liabilities, the growth option may be the better choice. On the other hand, if you prefer to accumulate more units over time and don’t mind paying taxes on dividends as they are declared, the dividend reinvestment option would suit you.