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:

In this postwe 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 inIDFC Arbitrage Fund (Direct Plan). He is confused between Growth or Dividend Reinvestment as which would be more beneficial for him. We take two cases :

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

Lets see how the returns change for Growth and Dividend Reinvestment options:

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

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%.

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

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

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

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

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

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?

Lets see how the returns change for Growth and Dividend Reinvestment options:

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

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.

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

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

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

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?

To summarizeDividend 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 isdividend distribution tax of 28.84% (25% + 12% Surcharge + 3% Cess). SoDividend 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.

Excellent article, well explained with example. Simple to understand.

I tried searching a lot to understand about taxation on Dividend reinvestment, finally stumbled upon your article.

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

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 13Investments to Generate Regular Incomewhich might be helpful.