Dividend Option: Falling Out Of Favour

Dividend Option: Falling Out Of Favour

The impact of the latest change in tax structure will get reflected in due course of time but there are other reasons too why the dividend option is on a decline. The report presents an in-depth explanation

The popularity of the ‘dividend option’ in mutual fund investment was anyways dwindling; however, the latest announcement of imposing stamp duty on the purchase of mutual funds will further dent its relevance. From the start of July 2020, mutual fund investors will have to pay stamp duty for every purchase of a mutual fund, including systematic investment plans (SIPs) and systematic transfer plans (STPs). It will be imposed at the rate of 0.005 per cent on the purchase or switch-in amount. Although it is not substantial and will have a negligible effect on your total returns from mutual fund investments, it will definitely hurt someone who has opted for a dividend reinvestment plan.

For dividend reinvestment, it will be imposed each time on the dividend amount that is reinvested, less tax deducted at source. That explains why this stamp duty will impact those who have opted for a dividend reinvestment plan. The graph below clearly shows how asset under management (AUM) under the dividend option has been declining in the last three years. It has come down from 18 per cent of the total AUM at the end of March 2018 to 7 per cent at the end of June 2020.



It is not only as a percentage of AUM but even in absolute terms that AUM under the dividend option has declined. This is despite the overall AUM of mutual funds being on the rise. Although it has declined in the current year, it is up by 8 per cent since the end of FY18’s total AUM. The graph below shows the decline in AUM of divided option in absolute terms.

The impact of the latest change in tax structure will get reflected in due course of time but there are other reasons too why the dividend option is on a decline. For the past 30 months the equity market has been in pain. If we exclude a few stocks from the equity indices, most of the other stocks have not fared well. This is reflected in the performance of equity mutual fund schemes and hence the frequency with which dividends are distributed has come down. Therefore we see many funds not announcing dividend for obvious reasons. Investors who were dependent on dividends by mutual funds for their regular income are of course disappointed and have started looking at other options.

Besides, the tax structure in the last couple of years has evolved in such a way that it discourages the dividend plan. Just few years ago there was no tax imposed on the dividend received from mutual fund investments. However, the 2018 Union Budget introduced a Dividend Distribution Tax (DDT) of 10 per cent for equity-oriented mutual funds. The dividend received by investors of equity MF schemes was earlier tax-free but from FY19 a DDT of 11.648 per cent, including surcharge and cess, was deducted by the fund house before distribution of dividend.

As such, investors now stand to receive a lesser amount as the net dividend is post-taxation. For example, for an investor having 100 units of a fund that has announced a dividend of Rs 1 per unit, he would now get only Rs 88.35 as compared to the earlier Rs 100. It will definitely hurt someone like a retiree who depends upon such receipts as a regular source of income. This new regulation treats every investor on the same level irrespective of his income and tax slab. The Union Budget of 2020 tried to correct it and abolished DDT. Nevertheless, it did not reduce the burden of tax or make dividend option attractive. In fact, the latest change in tax structure has increased the tax burden of individual investors falling in a certain tax slab.

Now, the dividend received from mutual fund investment is taxable in the hands of investors as per their income tax slab rate. Therefore, if you fall in the 30 per cent tax slab, you will have to pay tax at the rate of 30 per cent. Similarly, someone in the 5 per cent tax slab would have to pay tax at 5 per cent on mutual fund dividends, including debt and equity, while ignoring any surcharge and cess. This tax structure has only further tilted the needle against choosing a dividend option. Anyone in a tax bracket of above 10 per cent can wait for one year and redeem the units after that period, which will attract long-term capital gains (LTCG) taxation.

LTCG applies to gains in funds held for longer than a year and is taxed at a rate of 10 per cent. However, the first Rs 1 lakh of gain is tax-free. The short-term capital gains (STCG) taxation is for funds held for shorter periods and is 15 per cent. 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. 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.

Solution for Invetors

The dividend option of mutual fund was considered as a suitable option for many investors who wanted to have regular cash flows and were not interested in government schemes that offered lower liquidity and even lower returns. Nevertheless, the dividend option had a couple of demerits including the amount of cash flow that you need and the frequency with which you require it. Nevertheless, some of the mutual fund houses in some of their schemes announced dividend regularly and even every month. This partly solved the problem but the recent change in tax structure has made it unattractive.

Difference between MF and Cmopany

Dividend There is a big misconception among various investors that there is a similarity between companies paying a dividend and the dividend of a mutual fund. A company pays out a dividend from the profit it makes and so this is very good for the end investor. Whereas, in an equity mutual fund, the fund is paying you back your own money. If the NAV of a fund is Rs 20 and a dividend of Rs 2 is announced, the NAV will fall to Rs 18.

While dividends generally denote the additional returns for investments in shares, the concept of dividend under mutual funds is not the same. Since the NAV of a mutual fund scheme represents the net assets of the scheme, any declaration of dividend reduces the NAV to that extent, along with tax implications. Effectively, the valuation of the portfolio decreases too. In other words, dividend payout may be considered as partial encashment of your mutual fund investment.

There is one option available to such investors and that is opting for a systematic withdrawal plan (SWP). It will help you to remain in control of both the amount of cash flows and at what frequency you want it. If you have a corpus in a mutual fund, SWP allows you to set an amount you want to withdraw regularly and the frequency with which you want to make such a withdrawal. For example, if you have a corpus of Rs 10 lakhs in a mutual fund, you may decide to withdraw an amount of Rs 10,000 per month. Each month, therefore, your investment in the fund will reduce by Rs 10,000. The amount left every month after withdrawal will continue to remain invested.

SWP is also more tax-efficient. It allows you to get regular income from equity funds and to get the best out of the tax imposed on long-term capital gains accrued on the amount withdrawn through SWP. It allows tax benefit on long-term capital gains up to the amount of Rs 1 lakh. The investor will be liable to pay tax only on gains over and above Rs 1 lakh. For example, consider the option of investing Rs 30 lakhs in equity mutual funds from which you withdraw Rs 30,000 every month after the first one year of investment. Your withdrawal amount will be Rs 3.6 lakh in a year. Now consider that your investment grows at 12 per cent every year. In that case, you would be paying tax on an average 5 per cent of the amount withdrawn.

Therefore, we believe that investors should stop using the dividend option. Although it helps to book profit at regular interval and minimise the huge loss that you may see in a bad market year, overall experience shows that in the long-run growth option is better. There are options such as SWP that can solve an investor’s need for frequent and regular cash needs.

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