Home >Money >Personal Finance >How MF dividends return investors’ own money as taxable income
MF dividends can simply return your capital, forcing you to pay tax on your investment itself and not just the profits. (Photo: iStock)
MF dividends can simply return your capital, forcing you to pay tax on your investment itself and not just the profits. (Photo: iStock)

How MF dividends return investors’ own money as taxable income

  • The nature of mutual fund dividends is not the same as how dividends are commonly understood—distribution of profits
  • Sebi asks mutual funds to rename dividend plans as 'income distribution cum capital withdrawal' from 1 April 2021

Mutual Fund dividend plan assets have seen a 50% drop over the past year as Budget 2020 made dividends taxable at slab rates. In a circular issued on 5 October, the Securities and Exchange Board of India (Sebi) asked mutual funds to rename their dividend plans as “income distribution cum capital withdrawal" from 1 April 2021.

The regulator’s attempt was to highlight the peculiar nature of mutual fund dividends which make them different from how dividends are commonly understood—distribution of profits. MF dividends can simply return your capital, forcing you to pay tax on your investment itself and not just the profits. Despite this unfavourable tax position, a huge 1.79 trillion sits in the dividend plans of mutual funds, as of 30 September, data from Value Research shows.

MF dividends suffer from a twin problem. Unlike stock dividends, they are paid from both your capital and profits. As a result, you end up getting back your own investment in the form of dividend. From FY21, this dividend is taxable at slab rates, resulting in payment on tax on your capital.

Here’s an example to explain this. Let’s assume a mutual fund is launched at a net asset value (NAV) of 10 and appreciates to 15. You enter the mutual fund at 15 and it further increases to 17. At this point the fund books all its profits and declares a dividend of 7 and the NAV of the fund falls back to 10. You, the investor, will get back not just the profit on your investment ( 2) but also 5 which for you is your own capital. This entire dividend amount ( 7) is taxed at your slab rate (which could be as high as 30%) even though your real profit is only 2. Under Sebi rules, mutual funds are allowed to declare dividends from their realized profits. However these profits may well have been made before you entered the fund and, hence, they are not really profits for you.

“The original logic of dividends was the zero dividend distribution tax (DDT) on them before 2018 which compared favourably against the 15% short-term capital gains (STCG) tax on capital gains in mutual funds for holding periods up to one year. These were aggressively marketed in hybrid funds to FD investors after demonetization," said Vijai Mantri, co-founder and chief investment strategist, JRL Money, a mutual fund distribution firm. “This tax arbitrage got reduced with the introduction of 10% DDT in the 2018 budget. However, it was the 2020 budget which made them taxable at slab rates and completely finished the case for MF dividend options," he added.

The assets in the dividend plans of mutual funds dropped from around 4 trillion in September 2018 to 3.6 trillion in September 2019 before collapsing to just 1.79 trillion in September 2020 as investors shifted from dividend to growth plans of MFs. “We’ve switched out all our clients from dividend options because an SWP (systematic withdrawal plan) does a much better job. Dividend declaration by MFs in 2020 has also become negligible. There is no case to go for MF dividend options now," said Mantri.

Investors who remain in the dividend options of mutual funds should carefully evaluate whether they want to continue in such plans.

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