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Photo: iStock

Should you exit dividend options of mutual funds?

  • Those in higher tax bracket will end up paying more on dividends received from mutual funds
  • Those already in the dividend option of mutual funds should assess the cost of switching to the growth option

MUMBAI : Budget 2020 has abolished dividend distribution tax (DDT) on dividends declared by mutual funds. Instead, it has made dividends taxable in the hands of investors at their income tax slab rate. For instance, someone in the 30% slab will pay a tax at that rate, while someone in the 5% slab would pay tax at 5% on mutual fund dividends (debt or equity), ignoring surcharge and cess. This will apply from financial year 2020-21.

The new taxability rule on dividends is radically different from how dividends are currently taxed. In the existing system, equity fund dividends face a DDT of 11.65%, including surcharge and cess, and debt fund dividends 29.12%, including surcharge and cess. Once DDT is deducted, the dividend becomes tax-free in the hands of the investor. Thus, the new tax treatment actually increases the tax burden on investors in higher tax brackets, while lowering it for people in low tax brackets.

Within the dividend option of mutual funds, there are two options. First, the dividend payout option, where the money is directly transferred to the investor. Second, the dividend reinvestment option, where the fund house reinvests the dividend in the same scheme. “The dividend reinvestment option was introduced at a time where there was no DDT. It enabled investors to move between dividend payout and reinvestment smoothly with no cost for switching between the two. Such a switch was not treated as a redemption (but not anymore)," said Vishal Dhawan, founder, Plan Ahead Wealth Advisors, a financial planning firm. “After the introduction of DDT, it (dividend reinvestment option) became redundant," he added.

How tax on dividends will eat into your returns
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How tax on dividends will eat into your returns

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Huge impact

Approximately 3 trillion out of the total assets under management (AUM) of open-ended mutual funds of 23.29 trillion is invested in the dividend option. This amounts to around 12% of the total AUM.

In hybrid funds, the figure is much higher— 1.31 trillion of the total open-ended hybrid fund AUM of 3.74 trillion or 35% of the total is invested in the dividend option of hybrid funds (see graph). The new taxability rule on dividends will affect hybrid funds the most given that a large number of investors entered the category in 2016 and 2017 with the expectation of getting regular income through dividends.

However, mutual fund dividends depend on the performance of the fund in question. They can only be paid from the realized profits of the mutual fund. Hence, they cannot be in any way relied on for steady income. As markets became sluggish in 2019, the category witnessed relentless outflows.

“Anyone in a tax bracket above 10% who can wait (for the return of income) for at least one year should not invest in the dividend plans of equity funds. Even those who cannot wait for one year should avoid dividend plans, if they fall in a tax bracket above 15%," said Gaurav Awasthi, senior partner, IIFL Wealth Management Ltd.

The long term capital gains (LTCG) tax, which applies to gains in funds held for longer than a year is 10% (above a tax-free capital gains allowance of 1 lakh per year). The short-term capital gains tax (STCG) in funds held for shorter periods is 15%. Hence, investors in higher tax brackets are better off taking their returns as capital gains rather than dividends which will be taxed at the slab rate.

“For debt funds, the same argument applies for people who can wait for three years and are in a tax bracket above 20%," said Awasthi. Debt mutual funds face LTCG tax of 20% if held for more than three years. The benefit of indexation is also given to gains in these funds. “People in higher tax brackets will find the dividend option highly unfavourable to them compared to the growth option," said Suresh Sadagopan, founder, Ladder 7 Financial Advisories.

Budget 2020 has also proposed a 10% tax deducted at source (TDS) on mutual fund dividends. Experts have pointed out that this will add compliance costs for investors in the dividend option. “The TDS provision will also bring in the problem of reconciliation and additional compliance for investors," said Sadagopan.

Switching money from the dividend to the growth option of the same scheme or a different scheme is treated as a redemption. A mere switch can trigger an exit load and a tax liability. “People who are in the dividend option should compare the net benefit of switching against the exit load and tax triggered by the switch and then take a call on this," said Sadagopan. “A switch can attract tax, but since the NAV (net asset value) of dividend plans does not grow much (due to returns in the form of dividend), the applicable tax may not be very high," said Bhavesh Sanghvi, chief executive officer, Emkay Wealth Management.

What should you do?

Investment decisions should be made for wealth creation rather than narrow tax considerations. When you look at investments through this broad lens, you will find dividend options of mutual funds are less optimal than growth options. While investors tend to spend the dividends received as payout, a growth plan automatically adds the amount to your NAV and compounds the value. Just like dividend payout options, dividend reinvestment plans have become less tax-efficient than growth plans, post the budget.

Investors in higher tax brackets should avoid the dividend option of mutual funds. If you want regular cash flows from your mutual funds, you can set up a systematic withdrawal plan (SWP). These plans withdraw a fixed amount from a mutual fund at regular intervals, say, every month. However, SWPs do not guarantee regular income. They can eat into your capital if the returns from the fund do not match withdrawals. But they can provide regular cash flows for a certain number of months or years, depending on the size of your investments.

Even those who are in the lower tax brackets at present may see their incomes rise with time and, hence, be pushed into the higher bracket and, hence, need to be careful about their long-term investments.

Those who are already in the dividend option of mutual funds should compare the benefits of lower taxes on capital gains in case they switch to the growth option with the costs of redeeming their existing investments in the dividend option. Consulting a financial adviser may help them understand what works for them.

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