By Jimmy Patel, MD& CEO, Quantum Asset Management
The Union Budget 2020-21 abolished the Dividend Distribution Tax, which effectively is 20.56% (15% DDT + surcharge and cess, as applicable) for the current assessment year, i.e. 2020-21, on dividends declared by any domestic company.
In case of equity-oriented mutual funds, the effective DDT rate is currently 11.65% (10% DDT + surcharge and cess, as applicable), while on debt-oriented schemes 29.12% (25% DDT + surcharge and cess, as applicable).
However, from the next assessment year, 2021-22 (applicable to the financial year 2020-21) dividends earned will now be taxable in the hands of the recipient – by adding to the total income and taxed as per their applicable income-tax slab rate. Mutual fund houses before distributing dividend will deduct tax at source (TDS) @10% if the ‘dividend income’ in the hand of recipients exceeds Rs 5,000.
The Impact
While the above move would benefit individuals who pay less tax (due to the lower tax slab applicable) instead of the current effective DDT rate; for those in the higher income slab — the HNIs and Ultra — it is counterproductive. To simply put, it would increase the tax burden of individuals earning substantial dividend income and who are anyway subject to a higher income-tax rate on the total income earned.
So, s hould one choose the ‘Dividend Option’ when investing in mutual funds then?
Generally, investors looking for some sort of regular income or cash flow, opt for the Dividend Option while investing in mutual funds.
But a fact is that dividends are not guaranteed. Dividends are declared at the discretion of the fund house when the scheme is performing well, and perhaps making profits for investors.
Furthermore, choosing the Dividend Option end ups eating away the accumulated profit at regular intervals. This is because unlike equity shares or stocks where the dividend declared by the company is on the profits earned by the company, mutual funds dividends are paid out of the investment value, akin to ‘profit booking’ (the fund pays back the investor his/her money).
Besides, it is not true that by choosing the Dividend Option, the dividend-adjusted returns would be always greater than the returns clocked by the Growth Option.
When the ultimate goal is to grow wealth, choosing the Dividend Option could end up eating away the accumulated profit at regular intervals. This, in turn, could upset wealth creation and get in the way of compounding.
When investing in mutual funds, one would be better off choosing the Growth Option, as it holds the potential to compound wealth better (subject to mutual fund scheme selected).
Given the change in tax laws, it makes sense for investors who have opted for the Dividend Option to switch to the Growth Option – particularly those who are in the high tax bracket.
How can one address regular cash flow needs?
To generate regular income, instead of going for Dividend Option (where the tax impact could be high), choosing the Systematic Withdrawal Plan (SWP) would prove more prudent.
Systematic Withdrawal Plan (SWP)
Through an SWP, one can withdraw a fixed sum of money or the capital appreciation from a mutual fund scheme regularly (monthly, quarterly, half-yearly or annually), in a disciplined manner, and potentially continue to returns on the remaining investments over a period of time. So, an SWP brings along the following key benefits:
- Facilitates better planning of withdrawals, as per one’s need
- Particularly during retirement, can be the medium to source one’s monthly expenses
- Enable rupee-cost averaging
- And allow the remaining investments to benefit from the power of compounding
That being said, one needs to keep in mind the tax implications on withdrawals. This will depend on whether it is an equity-oriented or a debt-oriented mutual fund scheme.
If it is an equity-oriented mutual fund, the gains realised on the units held for a period of 12 months or more, a Long Term Capital Gain (LTCG) tax will apply. LTCG is taxed at a rate of 10% on gains in excess of Rs 1 lakh. No tax is applicable on gains below Rs 1 lakh.
For gains realised on equity mutual units held for a period of less than 12 months, a Short Term Capital Gain (STCG) applies. STCG is taxed at a rate of 15%.
Ideally, when investing in an equity mutual fund scheme, ensure that the holding period is at least 3 years and willing to assume high risk.
In case of a debt-oriented mutual fund, the holding period to classify short term and long term for capital gains is 36 months.
Gains realised on debt mutual units held for a period of less than 36 months are Short Term Capital Gains. STCG on debt funds is taxable as per one’s income-tax slab.
Whereas gains on debt mutual fund units held for a period of 36 months or more are classified as Long Term Capital Gains. The LTCG on debt funds is taxed at the rate of 20% with indexation benefits. The indexation benefit allows adjusting the purchase price of debt funds for inflation, and in turn, helps bring down the tax on capital gains.
Take prudent investment decisions in the interest of your financial wellbeing.
Happy Investing!