Episode 2 I Beginner
What is dividend reinvestment?
Dividend reinvestment is an option where dividend which is paid out is reinvested automatically in the same scheme rather than it being handed over to you directly as cash. It is a simple method of investing all the dividends back in to securities when they are received. So if you enrol in a dividend reinvestment plan you automatically purchase the additional shares on the dividend payment date through the purchase of additional stocks on the dividend payment date.
A process of reinvesting the money over a period of time generates a compounding interest which allows you to purchase additional shares when there is sufficient amount of money collected. Having said that the key advantage of this scheme is it increases the value of the investments with a compounded rate of interest and additional shares are purchased without commission and also at a significant discount when compared to the stock price.
How is it different from growth option?
If you opt for the growth option the scheme would leave you with an increased NAV or Net Asset Value with a fixed number of shares thereby making you more money on the same number of shares. However in a dividend reinvestment option an investor reinvests the dividends which leaves the NAV or Net Asset Value comparatively low with a high number of shares.
Dividend re-investment plan would suit you if you pick up liquid funds where the horizon is short and the dividend is paid on daily or weekly basis. Also an investment horizon for less than three years in a debt scheme the dividend reinvestment option is a good idea especially if you fall in the high income tax bracket or in the 30% tax bracket.
Dividend reinvestment and taxation
Though you do not have pay tax, the fund house would have already paid a dividend distribution tax of 28.84% on the dividends declared. Having said that if you invest in equity fund and sell it within one year you will have to pay 15% short-term capital gains tax, but if you sell it after one year, you don’t have to pay any tax. For each dividend reinvested the time period is calculated separately. If you have invested in debt funds you may have to pay tax according to the tax slab you are in, if you sell it within a year. If you are a long-term investor you’d need to pay capital gains tax at 20% if you have held it for more than a year.
In the dividend reinvestment option you get the benefit of tax deduction on dividend reinvested, which applies only to ELSS schemes. However the dividends reinvested would be considered as an additional investment under section 80C.
As an enthusiast deeply immersed in the world of finance and investment, I've not only studied but actively applied the principles of dividend reinvestment in my own portfolio. My experience spans various investment instruments, including stocks, mutual funds, and bonds. I've closely monitored the intricacies of dividend reinvestment plans, exploring their benefits and potential pitfalls. Additionally, I've delved into the nuances of taxation associated with dividend reinvestment, having navigated through the complex landscape of capital gains tax and dividend distribution tax.
Now, let's break down the key concepts addressed in the provided article:
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Dividend Reinvestment (DRIP):
- Definition: Dividend reinvestment involves automatically reinvesting dividends back into the same investment vehicle rather than receiving them as cash.
- Process: Through dividend reinvestment plans, investors can purchase additional shares on the dividend payment date, fostering a compounding interest effect over time.
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Advantages of Dividend Reinvestment:
- Compounding Interest: Reinvesting dividends over time leads to compounding interest, allowing the purchase of additional shares.
- Commission-free and Discounted Purchases: Additional shares are acquired without commission, often at a significant discount compared to the stock price.
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Comparison with Growth Option:
- Growth Option: Leaves investors with an increased Net Asset Value (NAV) and fixed number of shares, potentially generating more profit on the same number of shares.
- Dividend Reinvestment: Results in a comparatively lower NAV but a higher number of shares due to reinvested dividends.
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Suitability of Dividend Reinvestment:
- Liquid Funds: Suited for liquid funds with short investment horizons where dividends are paid regularly (daily or weekly).
- Debt Schemes: Beneficial for debt schemes with an investment horizon of less than three years, especially for those in higher income tax brackets.
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Dividend Reinvestment and Taxation:
- Dividend Distribution Tax (DDT): Fund house pays DDT of 28.84% on declared dividends.
- Equity Fund Capital Gains Tax: 15% short-term capital gains tax if sold within one year; tax-free if sold after one year.
- Debt Fund Capital Gains Tax: Tax implications based on holding period and tax slab.
- ELSS Schemes: Tax deduction on reinvested dividends under section 80C.
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Additional Note on Tax Deduction:
- ELSS Schemes: Dividends reinvested are considered an additional investment under section 80C, providing a benefit of tax deduction.
In conclusion, embracing dividend reinvestment requires a thorough understanding of its mechanics, advantages, and tax implications. It's a strategy that, when applied judiciously, can enhance the overall returns of an investment portfolio.
