How to maximize post-tax returns from mutual funds4 min read . Updated: 06 Oct 2011, 08:34 AM IST
How to maximize post-tax returns from mutual funds
How to maximize post-tax returns from mutual funds
Many invest regularly in mutual fund (MF) units, without fully understanding the tax treatment of MF transactions. Understanding the tax treatment may help you maximize returns since selecting a particular option of an MF scheme (dividend or growth) could make a significant difference to your post-tax returns.
Most investors are aware of the fact that income distribution by MFs is exempt, but many of them are not aware of the fact that such income distribution is subjected to tax in the hands of the MF itself. Such income distribution tax is borne by the particular scheme and, therefore, reduces the returns. Effectively, such income distribution tax is borne by the investors in that particular scheme. It is, therefore, important to understand the amount of such income distribution tax opposed to the capital gains tax. Accordingly, one should opt for either the dividend or the growth option of the particular scheme.
There is no income distribution tax in the case of equity-oriented funds; these are schemes in which more than 65% of the assets are equity shares. There is also no long-term capital gains tax in the case of such equity-oriented funds. However, there is a securities transaction tax (STT) applicable on the redemption of equity-oriented funds, which is 0.25% of the redemption value. Redemption of equity-oriented funds is subjected to short-term capital gains tax at the rate of 16.2225%, besides being subjected to STT. Of course, even under the dividend option, the redemption value would be subject to STT, but the redemption value would be lower to the extent of the dividend already distributed. Effectively therefore, under the growth option opposed to the dividend option, the additional STT that one is paying is on the value of the appreciation. The return is always subject to STT of 0.25%, which is not applicable to the dividend option.
Therefore, generally in case of investment in equity-oriented funds by individual investors, the dividend option is preferable to the growth option, even if the intention is to hold the units for a period exceeding 12 months.
Liquid and money market funds
In case of individual investors, the rate of income distribution tax for liquid funds or money market funds is 27.0375%. The short-term capital gains tax rate for investors in such funds is the respective slab rate of tax applicable to the investor—either 10.3%, 20.6% or 30.9%. The long-term capital gains tax rate (which may be applicable only rarely, given the short-term nature of such holdings) is 20.6% on the gains computed after indexation or 10.3% on the gains computed without indexation, whichever is lower.
Therefore, for most investors with taxable income in the lower tax slabs of 10.3% or 20.6%, the growth option is preferable, while the dividend option is advisable only for investors in the highest tax slab of 30.9%.
In case of other funds (debt funds, balanced funds and other funds not meeting the criteria of equity-oriented funds), the rate of dividend distribution tax is 13.51875% for individual investors. Here also, the short-term capital gains tax rate for investors would be the slab rates of tax in which they fall, while the long-term capital gains tax rate would be 20.6% on the gains computed after indexation. In case of such schemes, if the units are planned to be held for only 12 months or less, the growth option is advisable only for investors in the 10.3% tax slab, whereas the dividend option would be beneficial for unit holders falling in the higher tax slabs of 20.6% or 30.9%. If the units are intended to be held for at least 12 months, the gains would, therefore, be long-term capital gains; though the capital gains tax rate is 20.6%, the effective rate would be lower on account of the benefit of indexation. Further, the effective rate cannot exceed 10.3% of the capital gains computed without indexation on account of the lower of the two rates which would apply. Therefore, it is advantageous for a long-term investor to opt for the growth option, rather than the dividend option in case of such funds.
Therefore, the next time you invest in MFs, consider the type of scheme that you are investing in, the tax slab that you fall into and the intended period of holding and accordingly select either the dividend or growth option. This will ensure that you maximize your post-tax returns. Of course, if you do not need the regular returns that the dividend option gives you, or do not want the trouble of reinvesting the income distribution that you may receive which the growth option offers you, you may still choose a particular option which may not be the most tax-efficient. Ultimately, you need to strike a balance between maximizing your post-tax return and managing your liquidity.
Gautam Nayak is a chartered accountant.