Invest Less Save more tax by using Dividend Reinvestment for ELSS (Tax Saving Fund)

The “Investments for Tax Saving” Season is on and this post is in continuation with the previous few posts on ELSS (Tax Saving Funds). In one of the post I had said that you should either go for Growth or Dividend Payout Option but never with Dividend reinvestment option while investing in an ELSS. But is Dividend reinvestment totally worthless or we can actually use it for more efficient tax planning?

I received a lot of comments, questions, compliments & criticism on my last post Invest Rs 63,000 and save full Income Tax on Rs 1,00,000 under Sec 80C! from my friends & my readers. I request you to read the same but to maintain the continuity the situation was you were short of money and to save full tax on Rs 1 Lac you borrowed initially, invested in a dividend payout option of an ELSS fund which was going to pay a dividend, receive the dividend and paid back the debt.

But then is there some other way where we could do something without borrowing initially. Yes there is – Choose Dividend Reinvestment Option! Let me explain how the new strategy works.

Our situation is similar as in the previous case. Let me just summarize it.

You need to invest Rs 1 Lac to claim tax benefit under sec 80C but you are a bit short of money. Here I assume you have around Rs 75,000 (I assumed Rs 65,000 in previous case) and you don’t want to borrow. You have the same news “Birla Sunlife Mutual Fund has declared a dividend of 500% (i.e. Rs. 50/- per unit on face value of Rs.10/-per unit) under the dividend option of Birla Sunlife Tax Relief 96 fund. The record date for the same would be March 16, 2007.

So what are we going to do differently this time?

This is very similar to the strategy we used last time but instead of choosing dividend payout you need to choose dividend reinvestment option.

 This is how you do it

Step 1: Invest the entire Rs. 75,000 with you in Birla Sunlife Tax Relief 96 fund with Dividend reinvestment option on or before March 15, 2007. Let’s assume you invested on 15th March when the NAV was 135.23. So you would get 554.61 units.

Step 2: Actually you have now to do nothing. Just sit back, relax & think how smartly you saved the taxes!

So how it works?

You have 554.61 units and Rs 50/unit is the dividend declared. So your dividend comes out to be Rs. 27,730. Since you have Reinvestment Plan, the dividend declared would automatically be used to purchase more units for you with the NAV of 19th March (Post dividend NAV on next working day) i.e. Rs 84.7/unit. So you would get additional 327.39 units.

The ELSS rule says that each dividend reinvestment is treated as a fresh investment and gives you the same tax benefit as the initial investment.

So for all tax saving purpose what you have done is you have invested an additional amount of Rs. 27,730 along with Rs. 75,000 in ELSS for the year (though in reality you have invested 75000 only), which exceeds Rs 1 Lac limit for 80C tax saving investment.

Question time:

I don’t need to invest entire 1 Lac, as I have some investment in my EPF. Can you give me a simple formula to calculate how much should I invest to full fill my tax requirement?

Well it’s a simple formula.

Amount you need to invest = Tax investment required/(1+Dividend Yield)

Dividend yield = Dividend per unit / NAV on the day of dividend payout

We take the above example where you too want to invest entire 1 Lac in Birla Sunlife Tax Relief 96 before 16th March 2007. First we calculate the dividend yield.

Dividend Yield = 50/134.27 = 37%

Amount you need to invest to save tax on 1 Lac = 100000/(1+37%) = Rs. 72,993

You should mark up this investment by 1-2% to adjust for any NAV movements.

But as in the last approach of Dividend payout I could have myself bought units from the money received from dividend, why do I need to opt for reinvestment?

You are right. You can very well buy new units from the dividend payout money. But then you see the dates it’s already mid March and you don’t know till when dividend would be credited to your account and how much time you would take to buy new ELSS units. It may very well happen that you miss the deadline of 31st March.

Are there anymore benefits of this new approach?

I think one of the biggest benefits is that your investment like in case of growth option would create long-term wealth for you without any erosion in between due to dividend payouts. The second is the dividend declared in subsequent years would also automatically buy ELSS for you which would help you in reaching you goal of Rs. 1 lac Tax Saving investment without you even thinking about it. So it helps in further tax saving in subsequent years also.

And whats’ the catch?

First you need a higher starting amount. To save tax on Rs 1 lac – In dividend payout case you required initially Rs 63,000 while in this case you require Rs 73,000. The second disadvantage is liquidity. Payout option would give you regular dividends while in reinvestment your entire dividend is reinvested. And the third and biggest issue of dividend reinvestment is there is good chance that a portion of your investment would get locked in forever.


Historical records show that every ELSS fund declares a dividend at least once during any given three-year period. In a dividend reinvestment plan, the dividend gets reinvested into the fund. Any such reinvestment is considered fresh investment and gets locked in for three more years. Subsequent dividends declared on this reinvested amount get reinvested again for yet another three years. This way, you get into a vicious cycle of perpetual investment.

The way out

Most fund houses allow you to switch from a dividend reinvestment option to a dividend option. For this, you need to write a letter, requesting for a change and/or fill up a “change in option” slip at the bottom of your account statement. A switch to dividend option is easy. A switch to the growth option is also possible with some fund houses. However, your fund may impose a lock-in from the time you switch your units to the growth option.

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