Dividend Reinvestment Plan: What is it, Advantages, Limitations

Mutual funds are some of the most sought after investment opportunities in the financial market. Most mutual funds are categorized as growth plans and dividend plans, based on the manner in which the dividend must be treated. Growth plans look into value investing, whereas, in dividend pay out plans, the dividends are provided to the investors, providing them a steady source of income. This article seeks to explore one such variant of the dividend plan, which is the dividend reinvestment plan.

What is Dividend Reinvestment Plan?

It is a program that gives the investors the opportunity to reinvest their cash dividends into the mutual fund on the date of dividend payment. In this plan, the dividend that is to be paid out is reinvested at the post dividend NAV of the fund.

Do note that not all fund houses offer this option and it is the discretion of the mutual fund house to offer this option.

What are the advantages of a Dividend Reinvestment Plan?

·        The investors can see the compounding effect play its role efficiently. This is a valuable tool in long-term wealth creation.

·        It is advantageous to those funds that wish to create a loyal, long-term investor base.

What are the limitations of a Dividend Reinvestment Plan?

·        While the number of units increases in a dividend reinvestment plan, there are no additional returns that will be generated under the plan.

·        For equity and balanced schemes, it is better to choose a growth plan, as it will ensure that there is capital appreciation over a long term period.

What is the difference between Dividend Reinvestment Plan and Growth Plan?

Dividend Reinvestment Plan	Growth Plan
There is an increase in the overall unit holding of the investor and a higher capital gain.·      NAV reduces to the extent of the dividends though there is no direct payout.·    The total value of the growth and reinvestment plan reduces to the extent of the dividend being swiped out.	The value of the growth plan compounds over a period of time.  The fund manager has the discretion to invest the funds in more securities.·      NAV remains the same in the case of the growth fund.·        The total value of the growth and reinvestment plan is the same.·  This is a more preferred option in the case of equity mutual funds and balanced mutual funds.

A comparative analysis of Three Mutual Fund plans through an illustration

Parameters	Growth Plan	Dividend Plan	Dividend Reinvestment Plan
As on 1st January, 2020
NAV (in Rs.)	100	100	100
Units purchased	3000	3000	3000
Total investment (in Rs.)	3,00,000	3,00,000	3,00,000
As on 31st December, 2020
NAV (in Rs.)	150	150	150
Units purchased	3000	3000	3000
Total investment (in Rs.)	4,50,000	4,50,000	4,50,000
Dividend declared on the date	N.A.	Rs 1.5/unit	Rs 1.5/unit
Dividend paid to unitholders	N.A.	Rs 45000	N.A.
Dividend reinvestment amount	N.A.	N.A.	Rs. 4,500
Post dividend NAV (in Rs)	N.A. remains the same	135	135
Units issued for dividend reinvestment	N.A.	N.A.	333.33
No. of units post DRP	N.A.	N.A.	3333.33
Value of investment post dividend	Remains Rs 4,50,000	Rs 4,05,000	Rs 4,49,999.9

Conclusion

In the Union Budget of 2020, dividends received from equity shares or mutual funds have been made taxable at the Income Slab of the investor. There is a TDS of 10% if the amount payable is over Rs 5000 from a particular mutual fund or company. After this development, the Dividend Distribution Tax (DDT) paid by the AMCs or companies is not valid anymore.

With this development, investment in a dividend reinvestment plan may not hold much value to the investor, as there is no real dividend being paid on a mutual fund plan unlike the dividend paid on an equity share. Moreover, you will have to pay tax on that amount. So it may be worthwhile to switch to a growth plan of the mutual fund after taking into effect the other charges like exit load or capital gains taxes.

Frequently Asked Questions

1. What is the technique used to calculate DRP amount?D
RP amount is calculated with the help of a technique that is known as rupee-cost averaging which enables one to average out the amount at which one buys a stock over a particular period of time.

2. Which option is more advisable for long term financial planning?
If one wishes to keep their money invested in mutual funds for a long period of time, then growth plans are better investment choices.