Dividend payout option does not give any tax advantage

  • Choosing growth option along with a systematic withdrawal plan works better for mutual fund investors
  • If you need cash flow, then select the SWP, which is not only tax-efficient but also does not create the illusion that this is additional income

Does the investment option you choose in a mutual fund scheme impact the final outcome of your investment or is it just one more tick in the application form that you make without thinking too much about it?

Investors in mutual funds can structure the way they receive the returns from their investment as dividend or capital gains by choosing the dividend and growth options respectively. A quick recap of the way mutual funds generate returns will not come amiss here to understand these options.

A mutual fund collects the contributions made by different investors and invests the money in a portfolio of equity and debt instruments depending upon the investment objective of the scheme. The portfolio earns dividend on the shares held, interest income on the bonds and debentures, and capital gains or losses on the securities held in the portfolio. The combined returns earned from all these sources are reflected in the net asset value (NAV) of the scheme, which is the net of the costs associated with the scheme.

The options

Mutual funds offer the dividend option and the growth option to investors to decide on how they want to enjoy the returns. In the dividend option, a portion of the return is paid out periodically to the unit holders.

However, there is no guarantee and the dividend is paid only if there are realized income and gains in the mutual fund scheme.

The dividend option has been at the root of many misconceptions that investors in mutual funds hold.

First, investors believe that the dividend is an additional return they receive, like the dividends on equity shares, over and above the gain in the NAV. But in a mutual fund, the NAV represents the entire claim that each unit held by the investor has on the returns generated by the mutual fund and any dividend paid is out of this NAV. The NAV will, therefore, go down to the extent of dividend paid.

In the growth option, the investor chooses to let the investment grow till they need the funds and then redeem the units as required. In the growth option, the return is monetized only at the time of redemption. The NAV reflects the value of the units and the returns are allowed to compound over the period of holding.

Dividend or growth?

The dividend option has been advocated as the way to earn regular cash flows from the mutual fund investment. The impression that the dividend is an extra return has made investors choose this option to the detriment of their long-term goals which will suffer because the dividends actually bleed the long-term corpus that is being built and reduces the compounding benefit to the portfolio.

“Investors choose the dividend option on the basis of two misconceptions—one, investing in debt funds with monthly dividend option is equivalent to getting monthly income from the mutual funds, and second, that this dividend is profits that they are reaping out of their mutual fund investment over and above the NAV. We constantly dissuade them of these notions and try and educate them that the dividend is coming out of their investment," said Srikanth Meenakshi, founder and COO, FundsIndia.com.

There have been instances of misselling, too, where the dividend is projected as a guaranteed feature. The latest instance involved the balanced fund category in 2017, where fixed income investors were lured into these schemes on the basis of the continuous dividend paying record of the schemes in the good equity market scenario of 2015-2017. However, this ended when markets crashed in 2018, and the category since then has been seeing huge outflows every month.

A better way to generate regular cash flows from mutual fund investments is to redeem units periodically to the extent required. Unlike the dividend option where there is no certainty on the amount of dividend and the dividend decision is made by the fund management, mutual funds provide the facility of systematic withdrawal plans (SWP) where investors can specify the amount of money required and the periodicity and the mutual fund will execute it by redeeming the required number of units. Using the SWP option gives certainty of income that is not there in the dividend option.

“You must not confuse return with cash flow. If you need cash flow then you must select the SWP, which is not only tax-efficient but also does not create the illusion that this is additional income," said Aashish P. Somaiyaa, managing director, Motilal Oswal Asset Management Co. Ltd. The drawback, if it can be considered that, is the capital invested may also be withdrawn over time. “As long as your annual withdrawal rate is well below the expected return and you judiciously calibrate the process where needed, your capital remains intact over time," said Somaiyaa.

The tax angle

The dividend and growth option were played-off against each other since the tax treatment of returns as dividend and as capital gains were taxed differently.

But with a 10% dividend distribution tax now being imposed on dividends that are distributed and a long-term capital gain tax of 10% on gains over 1 lakh per annum in case of equity funds, and a dividend distribution tax of 25% and LTCG of 20% with indexation benefits on debt funds, the choice becomes a little more nuanced.

How do they stack up? In case of equity funds, the DDT of 10% is applicable on the entire amount of dividend. If a systematic withdrawal plan was used to withdraw a specified amount, then the tax will apply only on the capital gains over 1 lakh per annum and not on the total amount withdrawn. Take the example of a household that has accumulated a corpus of 20 lakh and requires a monthly income of 20,000 to meet the college expenses of their child (see graph). The table gives the two options and the tax implications for the investor.

The SWP option to generate post-tax returns is clearly superior to the dividend option. In case of debt funds, the availability of indexation benefits on long-term capital gains makes the SWP option even more attractive from a tax perspective. In the SWP option the units held will go down as redemption happens. In the dividend option, the NAV will deduce as dividends are paid out.

The dividend re-investment option, a sub-sect of the dividend option, hits the investor twice-over with tax. First, the DDT is deducted when the dividend is paid, even if it is re-invested in the same scheme. Second, when the investor withdraws the investment, there is a capital gains tax, too, that they are liable to pay. This double tax whammy makes this option completely useless for the investor seeking growth in investments.

Mint’s take

Investors in mutual funds are looking for either long-term capital appreciation or income from their investments. The dividend pay-out and re-investment option does not give investors any advantage in either of these goals on a post-tax basis. The combination of growth option along with a systematic withdrawal plan is what works for investors in the current tax scenario. Investors should consider switching their investments into the growth option to limit the damage. Remember, there are exit loads and taxes applicable on such switches, which need to be taken into account.