Union Budget 2020-21 removed the Dividend Distribution Tax, which effectively was 20.56 per cent (15 per cent DDT + surcharge and cess, as applicable) for the current assessment year, 2020-21, on dividends declared by any domestic company.

In the case of equity-oriented mutual funds, the effective DDT rate is currently 11.65 per cent (10 per cent DDT + surcharge and cess, as applicable), while on debt-oriented schemes, it is 29.12 per cent (25 per cent DDT + surcharge and cess, as applicable). However, from the next assessment year, 2021-22 (applicable for FY2020-21), dividends earned will be taxable in the hands of the recipient — by adding to the total income, and taxed as per their applicable income-tax slab rate.

Mutual fund houses, before distributing dividend, will deduct tax at source at 10 per cent if the ‘dividend income’ in the hand of the recipients exceeds ₹5,000.

The impact

While the move would benefit individuals who pay less tax (due to the lower tax slab applicable) instead of the current effective DDT rate, for those in the higher income slab — HNIs (high net worth individuals) and ultra HNIs , it is counterproductive. To simply put, it would increase the tax burden of individuals earning substantial dividend income and who are anyway subject to a higher income-tax rate on the total income earned.

So, should one choose the ‘dividend option’ when investing in mutual funds?

Generally, investors looking for some sort of regular income or cash flow, opt for the dividend option while investing in mutual funds.

But the fact is that dividends are not guaranteed. Dividends are declared at the discretion of the fund house when a scheme performs well and perhaps makes profits for investors.

Furthermore, choosing the dividend option end ups eating away the accumulated profit at regular intervals. This is because unlike equity shares or stocks where the dividend declared by the company is on the profits earned by the company, mutual fund dividends are paid out of the investment value, akin to profit-booking (the fund pays back the investor his/her money).

When investing in mutual funds, one would be better off choosing the growth option, as it holds the potential to compound wealth better (subject to the MF selected).

Given the change in tax laws, it makes sense for investors who have opted for the dividend option to switch to the growth option — particularly those who are in the high tax bracket.

How can one address regular cash flow needs?

To generate regular income, instead of going for the dividend option (where the tax impact could be high), choosing the Systematic Withdrawal Plan (SWP) would prove more prudent.

Systematic withdrawal plan

Through an SWP, one can withdraw a fixed sum of money or the capital appreciation from a mutual fund scheme regularly (monthly, quarterly, half-yearly or annually), in a disciplined manner.

So, an SWP facilitates better planning of withdrawals as per one’s need, particularly during retirement; can be the medium to source one’s monthly expenses; enables rupee-cost averaging; and allows the remaining investments to benefit from the power of compounding.

That being said, one needs to keep in mind the tax implications on withdrawals.

This will depend on whether it is an equity- or a debt-oriented mutual fund scheme.

If it is an equity-oriented MF, on the gains realised on the units held for a period of 12 months or more, long-term capital gains (LTCG) tax will apply. LTCG is taxed at a rate of 10 per cent on gains in excess of ₹1 lakh. No tax is applicable on gains below ₹1 lakh.

For gains realised on equity mutual units held for a period of less than 12 months, short-term capital gains (STCG) tax, at a rate of 15 per cent, applies.

Ideally, when investing in an equity mutual fund scheme, ensure that the holding period is at least three years.

Gains realised on debt mutual units held for a period of less than 36 months are STCG. STCG on debt funds is taxable as per one’s income-tax slab.

Gains on debt mutual fund units held for a period of 36 months or more are classified as LTCG.

The LTCG on debt funds is taxed at the rate of 20 per cent with indexation benefits. The indexation benefit allows adjusting the purchase price of debt funds for inflation, and in turn, helps bring down the tax on capital gains.

Take prudent investment decisions in the interest of your financial well-being.

The writer is MD and CEO, Quantum Asset Management Company

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