Dividend on Mutual Funds: Does it really makes sense?

Dividend from mutual funds was the biggest selling point in 2017, as it was sold as a REGULAR INCOME from mutual funds and that also TAX FREE. 

But is this really so and does it really makes sense to have dividends from mutual fund schemes especially in current tax rules according to which the dividend payment is subject to Dividend Distribution Tax (DDT) which is 10% (effective rate is11.648 % after including surcharge and cess if you add the effect of “grossing up”, the full tax rate is 12.942%) in case of Equity Schemes and 28.84% for other than Equity Schemes. Sales people tell the investors that it is still tax free in the hands of the investors, True, but ultimately the DDT is paid out from the income/gains of the investors fund only and the returns get reduced by the same amount so how does it makes a difference whether the Mutual fund company pays DDT or investor pays tax on it?

So let’s understand more about Dividend by Mutual Funds and its implications.

What is Dividend?

According to Oxford Dictionary:  Dividend is A sum of money paid regularly (typically annually) by a company to its shareholders out of its profits (or reserves).

Which means that when companies make a profit, they bring some of it back in the business, and distribute the rest to shareholders.

How is it Different in case of Mutual Funds?

In case of mutual funds, the fund management company works as a custodian to the funds of the investors. Here all gains/losses belongs to investors, after deducting the management expenses which could be up to about 3% of the total portfolio.

Therefore whether the money comes as dividend or as withdrawal, there is no difference in total gains to the investors, except the taxation which is applicable differently in case of dividend and capital gains.

What is the Tax implication on Mutual Fund gains?

Mutual Fund tax implications are different. Lets understand it more.

Let’s say the value of our investment in a mutual fund is ₹1 lakh, and then the fund gives 10% dividend means ₹10,000 as dividend. In that case the value of that investment will be reduced to ₹90,000.

Now for debt funds, what we receive is actually ₹7,116 because the debt fund would withhold 29.12% of the dividend and pay ₹2,912 as tax to the government. Which means by taking dividend we have reduced our total investment value from ₹1 lakh to ₹97,088.

In equity funds, there was no such tax till 2017-18. However from April 2018, even in an equity fund, there’s a 10% tax. So after accounting for the surcharges, we will get only ₹8,706 as dividend as ₹1,294 will be paid to the government. Which means by taking dividend we have reduced our total investment value from ₹1 lakh to  ₹98,706.

There is another investment option which is called as Dividend Reinvestment. Earlier it was popular because it led to lower taxation. However now, it actually have double impact of taxation on the investments as the money to be reinvested after dividend declaration will be net amount after paying dividend distribution tax and further there’s a 10% tax on long term capital gains. Even though the percentage of tax on capital gains is the same as dividend, however new returns in the hands of investors will be severely impacted because the dividend tax constantly reduces the amount available for further growth.

So does it really makes sense to opt for a dividend plan?

Absolute No. There is no sense of opting for dividend option except in case of corporates who are in top tax brackets and invest in liquid funds dividend option which has lower taxation as compared to their respective income tax bracket.

So What could be the alternate for regular cash flow?

For those who were opting dividend option just to get some tax free money it is better to continue in growth scheme which will help in creating long term wealth by compounding effect.

However for those who needs regular cash flow (like retired person without any regular income) there is one option called as Systematic Withdrawal Plans (SWP). In SWP investors can specify amount and date for withdrawal and money will be credited to their accounts accordingly by redeeming respective units. These are almost good enough as it will have fix amount and date so as to match the requirements.

What are other points to consider?

As said earlier the mutual funds withdrawal have Short Term Capital Gain Tax if redeemed before one year (for equity funds and three year for debt funds) and Long Term Capital Gain Tax which should be kept in mind. There are some schemes who charge exit penalty on withdrawal which is generally 1% and applicable for withdrawal before one year although it will have very negligible impact but one should consider it while opting for the SWP.  

Further the fact is that whatever amount we withdraw it will reduce our total investment value, So while withdrawing any amount we need to keep this in mind that our future growth on the investments will be reduced by that much amount including the compounding impact of the withdrawal amount.  Therefore we should withdraw only that much amount which is actually required.

Finally whether a person needs regular cash flow our want long term wealth creation dividend option cannot be the best option in either case and we should be wise enough to choose the right option based on our specific requirements.