Dividend distribution taxWilliam J Bernstein, an investment guru and author of The Investor’s Manifesto gave us a famous phrase about dividends. “Milk from cows, eggs from hens, a stock by god, for its dividends,” he wrote. Unfortunately this is simply not true of mutual funds anymore. Buying a mutual fund for its dividend has become a tax and return inefficient proposition. This is because mutual fund dividends are simply distributions of existing value and they do not indicate any value. In case of stocks, regular dividends can be a sign of sound management. Here’s how they work:

There are two dividend options in mutual funds – dividend payout and dividend reinvestment.

Dividend Payout Option

Dividend payout actually pays the fund’s dividend into your bank account. For equity funds, this was earlier tax-free. However, Budget 2018 imposed a 10% tax on it. Dividends paid out by a mutual fund will attract a 10% tax which will be paid by the fund at the time of distribution. The dividend will be tax-free in your hands because the tax will have already been deducted.

In case of debt funds, dividend payouts attract a dividend distribution tax (including cess) of 29.12% (25% tax, 12% surcharge and 4% cess). The cess was earlier 3% and has been increased to 4% by Budget 2018. This tax is also paid by the fund at the time of distribution and the dividend you receive is tax-free.

You might argue that the alternative, choosing the growth option, also attracts long term capital gains tax (LTCG) of 10% or short term capital gains tax (STCG) of 15%. Long Term Capital Gains Tax (LTCG) is attracted if you hold your equity fund units for 1 year and Short Term Capital Gains Tax (STCG) is attracted if you hold them for a shorter period, before selling. However, note that these taxes are only liable to be paid when you redeem your units. And you can set off these gains against any losses as well.

The dividend distribution tax, on the other hand, is paid out whenever the fund declares dividends and this is completely out of your control. If the money were left with the fund instead (as with the growth option), this 10% would have been reinvested and grown substantially over time. In addition, you get a tax exemption of Rs 1 lakh per year on your long-term capital gains which you do not get with dividends.

Dividend Reinvestment Option

The dividend reinvestment option invests the dividend back into the fund instead of paying it out to you. Before Budget 2018 imposed the 10% tax, this act of reinvestment was tax-free and hence it gave returns more or less equal to the growth option. However, after Budget 2018, a 10% tax will be deducted every time a dividend is reinvested back into the fund.

This makes it the worst option of the lot, you pay tax on dividends without actually getting them in your bank account. You might wonder why this option exists at all. The reason is a historical anomaly. Several years ago, capital gains were taxable while dividends were tax-free. As a result, fund houses offered the dividend reinvestment option as a way for investors to reduce their tax burden. However, this historical situation is long dead and gone. In case of debt mutual funds, dividend reinvestment attracts the same at roughly 29% tax.

There is one final misconception about dividends that many investors have. They think that dividends are a substitute for the monthly interest that FDs or bonds pay. This is utterly untrue. Mutual fund returns are not guaranteed while FD interest is guaranteed unless the bank itself goes bankrupt.

You cannot rely on mutual fund dividends for regular income while you can do so with bank FDs. If you want to take a regular income from a mutual fund, choose a systematic withdrawal plan (SWP). This type of plan withdraws a fixed amount per month from the fund.

Note that an SWP is not just an ‘income withdrawal.’ It can also eat into your capital if the fund does poorly. However, you will get a fixed amount per month, as long as there is sufficient balance in your mutual fund holdings. If you keep your SWP withdrawal low enough, your fund can last (and even grow) for a long long time.

Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.