Currently dividends from Mutual Funds are tax-free in the hands of investors. Investors don’t have to pay income tax on the dividend income from their Mutual Fund investments. The fund house deducts a Dividend Distribution Tax (DDT) from the distributable surplus (profit) of the fund to calculate net distributable surplus. This amount is distributed in proportion to the units held in the fund by all those investors who have opted for dividend option.
If an investor has not opted for dividend option but has instead chosen growth option, he/she doesn’t get impacted by DDT. In this case, the profits made by the fund (also known as distributable surplus) is reinvested to grow the asset base of the fund. Thus, a growth scheme investor will experience an increase in the NAV of his units while he/she continues to hold the same number of units. Growth option investors benefit from the power of compounding over the long-term as profits are reinvested in the fund.
A dividend reinvestment option allows investors to reinvest the dividend declared by the fund, but this reinvested dividend amount is lower than the NAV increase that the Growth option investors experience because all dividends are declared only after deducting DDT. If you are a long-term investor, choose Growth option over Dividend Reinvestment.