Dividend Or Growth: Whats The Best Option?

Hemant Rustagi Chief Executive Officer, Wiseinvest Advisors 

A lot was expected by mutual fund investors from Union Budget 2020. However, it turned out to be a disappointing one for them. To begin with, it has proposed that dividends from mutual fund units in both equity as well as debt-oriented funds will be taxed in the hands of unit holders at the applicable rate. Currently, equity and debt funds are required to pay Dividend Distribution Tax (DDT) of 11.64 per cent and 29.12 per cent (including surcharge and cess) respectively before paying dividend to unit holders. However, dividend is tax-free in the hands of investors. The budget has also proposed TDS of 10 per cent if dividend from mutual funds exceeds Rs 5,000 in a year.

The taxation of dividends in the hands of mutual fund investors is actually a mixed bag for those looking to generate regular income through the dividend option. While those with income lower than Rs 5 lakhs (including dividend amount) will benefit as they will not be required to pay any tax, others in the higher tax bracket will lose out as they will have to pay higher tax. Of course, investors in the 20 per cent tax bracket will benefit if they have opted for dividend payout in debt funds. It is also important to understand that even those who have opted for dividend reinvestment will also get impacted. Dividend reinvested during the financial year will have to be included in income and taxed as per the applicable slab.

As for TDS of 10 per cent on dividend, it is important for investors to understand that TDS is different from DDT. DDT is a tax paid by fund houses before distributing dividend and investors can’t claim any refund against that. TDS is deduction of tax at source before distributing dividend. Therefore, if an investor falls in the lower income tax slab, he or she can claim a refund while filing Income Tax returns. However, if the applicable tax rate is higher, the remainder tax would have to be paid after deducting tax set-offs.

Considering these changes, one has to analyse the current option and choose the right one to enhance post-tax returns. Since there is more than one reason for investors to opt for dividend option, the strategy would depend upon the reason for which one has opted for dividend option. First, there are investors who really need to generate regular income to supplement their other income to meet their expenses. While investors in the lower tax bracket, as compared to the current rate of DDT, can continue with the dividend option, those in the higher tax bracket will have to rethink their strategy.

One such strategy is to redeem units in a disciplined manner through Systematic Withdrawal Plan (SWP). This can reduce tax liability considerably as long-term capital gains (LTCG) in equity funds are taxed at 10 per cent (plus surcharge and cess) and LTCG up to Rs 1 lakh in a financial year is tax-free. Second, there are investors who chose to receive dividend as it was tax-free. Clearly, the need for regular income wasn’t the criteria here. For some reason, many of them have continued to remain under the dividend option despite introduction of DDT in the Union Budget 2018. This set of investors will do well to switch to growth option so as to benefit from compounding as well as lower LTCG.

Third, there are investors who use dividend option as a strategy to book some profit on a regular basis without having to worry about market timing. They will also be better off moving to growth option and redeem units as per their needs. Although it is evident that SWP can be a better option for investors than continuing in dividend option, not many of them have clarity on this concept. Besides, many of them don’t want to redeem their investments for the fear of their original investment getting wiped out over time. In reality, SWP is a mandate given by an investor to the fund house to redeem units worth a certain amount from a pre-decided fund and on a fixed date.

For example, an investor can opt for SWP of Rs 10,000 per month on the first day of every month for a certain period. This ensures regularity in receiving money despite varying degree of volatility in the stock market. As for the fear of losing original investment amount over time, this fear is unfounded. While it is true that units get reduced on account of redemption, the NAV of growth option is much higher on account of compounding and as a result the investment value is usually higher than under the dividend option over a longer term.