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Opt for dividend plan in ELSS- It has more to offer than meets the eye

A successful investment strategy involves optimisation of four factors — risk, return, liquidity and tax-efficiency. However, under current regulations, tax-saving investments are not possible beyond a certain limit.

Under section 80C of the income tax act, a total investment of Rs 1 lakh in specified avenues is eligible for deduction from the total annual income. Moreover, instruments eligible for tax benefits under section 80C come with a lock-in period of three to five years, restricting the liquidity of such investments.

Among all these instruments, the equity-linked saving scheme (ELSS) of mutual funds offer certain advantages that enable the investor not only to invest less than Rs 1 lakh to get the same tax benefit, but also earn a higher return.

Go for the dividend plan

Almost all equity-linked saving schemes have two fund options — growth and dividend. Unlike a growth plan, an investor gets annual payouts from the dividend schemes before the final redemption of units.

The trick here is to invest in the dividend plan of an ELSS. For instance, if one invests Rs 1 lakh in an ELSS, one saves a tax outgo of Rs 33,990 (at the highest tax rate of 33.99 per cent) under section 80C.

Now consider this. An ELSS has announced a dividend of 50 per cent. The net asset value (NAV) per unit of the scheme is Rs 50. Suppose one invests Rs 1 lakh in the fund before the record date for the dividend. After the record date, the investor will get a dividend of Rs 10,000 at the rate of Rs 5 per unit for 2,000 units that have been bought. Therefore, effectively the individual invests Rs 90,000 (Rs 1,00,000 minus Rs 10,000) and saves Rs 33,990 in tax outgo.

In other words, on an investment of Rs 1,00,000 in the dividend plan of the ELSS, one gets a post-tax return of Rs 43,990 (Rs 33,990 plus Rs 10,000), or 43.99 per cent.

However, the NAV in a dividend plan declines to the extent of the dividend payout. This means that post-dividend the NAV will be Rs 45.

Traditionally, an ELSS has given dividends at a much higher rate than diversified equity schemes (non-tax saving) of mutual funds. For example, SBI Magnum Taxgain gave a 110 per cent dividend, Principal Personal Taxsaver 420 per cent, Franklin India Tax Shield 80 per cent, HDFC Long Term Advantage 60 per cent, HDFC Taxsaver 80 per cent and ICICI Pru Tax Plan 40 per cent in financial year 2007-08.

Rush hour

But it is seen that soon after the dividend announcement, investments in these schemes rise sharply with investors making a beeline to get the high dividends. The increase in cash flows helps the fund managers rev up investments and stem the decline in NAV.

Moreover, since one cannot redeem units in an ELSS within three years from the investment, there is no immediate rush for redemption for “dividend stripping”.

Mutual funds give high dividends under ELSS because in the absence of regular redemption pressure (as in the case of an ordinary equity scheme) the corpus of the fund grows. They distribute dividends aggressively to bring down the asset under management at moderate levels.

NAV growth

The dividend plans of ELSS are more beneficial than ordinary diversified equity schemes because the growth in NAV of ELSS is more.

Over the last five years, such schemes have given an annualised return of between 33 per cent and 70 per cent. On the contrary, the annual return of ordinary diversified equity schemes during the same period was between 30 per cent and 65 per cent.

Greater liquidity

The dividend income also provides some liquidity to ELSS investors. Dividend income being tax-free, investors don’t have to show this in their annual income tax return.

Instead, this payout can be reinvested every year in other mutual fund schemes, preferably in ordinary open-ended diversified equity schemes that provide more liquidity.

One can also reinvest this dividend income in a Public Provident Fund — the best option for fixed income investment.

Mutual funds generally announce dividends under their equity-linked savings schemes during the last quarter of a financial year. This is because most investors rush to make tax-saving investments during this time. Mutual funds try to attract them with lucrative dividend baits.

However, since April 2006, the Securities and Exchange Board of India has restricted mutual funds from announcing dividends in any of their schemes not more than five days before the actual payout day (record date).

Earlier, mutual funds announced the dividend payout a month in advance of the record date.

One can also invest in the dividend plan of an ELSS at the beginning of a financial year and reap the dividend at the end of the year when it is announced, while the investment grows during the intermediate months.

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