Dividend Option in Mutual Fund Investments and Tax Implications

Why Dividend Option in Mutual Funds are to be Skipped

Roboadviso     Mutual Funds     Posted On, Wed 11th July, 2018     No comments
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The so-called dividends associated with mutual fund investments need to be phased out. It is important to eliminate the dividend option and replace it with different specially drawn withdrawal schemes that can be selected by investors as per their requirements. It is important to note that the dividend option in mutual funds is not actually a “dividend” and abolishing it would not be a drastic step. The so-called dividends of mutual funds are not actually dividends, but misleadingly named withdrawal plans. They are just options with random structures created by mutual fund houses to meet their own marketing objectives.

According to different sources like Wikipedia, Oxford dictionary, etc., the word dividend is defined as an amount of money that is regularly (often on a yearly basis) paid to the shareholders by a company out of the profits it makes or out of its reserves. It is also defined as a payment that is paid to the shareholders by a corporation, typically as a part of sharing of its profits. Another definition of a dividend is that it is an allocation of a chunk of the earnings of a company to its shareholders.

All of the above mentioned (as well as many others) definitions of a dividend refer to just ‘one’ and the same fact. It states that when profits are made by a company, a chunk of the profits is re-invested into the company, while another chunk is distributed amongst the company’s shareholders. The matter of allocation of the percentage of the profits to the company’s shareholders as dividend rests entirely with the management of the company. The management can decide whether to pay 5 percent or 10 percent or 0 percent of the profits as dividend. It may be noted that there are lots of businesses that share really low percentage of their profits or none at all, for different kinds of reasons.

But none of above discussed definitions of a dividend is applicable to the dividends option in mutual funds. In mutual funds investors get 100 percent of the profits that their fund portfolio makes, barring the 2 to 3 percent fees and portfolio management charges. The profits can be taken by the investor as dividends or as withdrawals, with taxes being the one and only difference.

  • For example, if you have invested in mutual funds and its total value is INR 2 lakhs, and if the fund house offers a dividend of INR 10,000, then the value of your mutual fund investment will decrease by INR 10,000 to INR 1, 90,000.
  • Dividends for debt funds attract a tax of nearly 29 percent, which is deducted at source by the fund before payment of the dividend. Thus, the (almost 29 percent) tax will be deducted from the INR 10,000 dividend and you will receive only INR 7,100 as debt fund dividend.
  • Such tax was not present in equity fund dividends till 2017. A new tax of 10 percent was introduced for equity mutual fund dividends in 2018. With the addition of surcharges, you will receive around INR 8,800 as equity fund dividend after tax deduction at source from the INR 10,000 dividend.

All of the above facts mentioned in the example indicate that selecting the dividend option for mutual funds is definitely not a sensible one. It also means that the misnamed dividends linked to mutual funds really do not offer any benefits and are basically useless. They are deceptive and artificial instruments of marketing. The new 2018 tax rules that became applicable on equity fund dividends mean that you will end up paying more taxes than necessary. It is a certainty that investors who have selected the dividend option on mutual fund investments are paying taxes that they should not have to.

Dividends are a good source of regular income. So if the dividend option is not chosen, then what are the alternatives to receiving regular income via mutual fund investments? The simple answer is that you can chose the growth scheme of mutual fund instead of the dividend option and then regularly withdraw a minor sum from the investment. The taxes in case of withdrawal plan will most likely be lesser as compared to dividends; this is because the full amount of dividend is taxed, while just the gains part in a withdrawal (and not the full amount) gets taxed.

There are some kinds of investments from the past that are faring more worse. In the days gone by, one option of investment was ‘dividend reinvestment.’ It was popular with investors as it helped reduce the tax burden. However, due to the taxes on equity and debt dividends, your money on such investment methods actually ends up getting significantly reduced and destroyed. A 10 percent tax is currently levied on dividends as well as LTCG (long term capital gains). It may however be noted that LTCG is levied only when investors sell off their mutual fund investment.

The mutual fund houses deduct the tax at the source whenever there is a reinvestment or payout of a dividend. The reinvestment method thus effectively causes the total value (money) of investment to keep decreasing. The tax percentage levied on dividends and LTCG may be the same, but the final returns on investment will be seriously affected due to the dividend taxation continuously decreasing the total sum that remains for further investment expansion.

The alternative to the dividend option is easy and simple. You may opt for the SWP or systematic withdrawal plan options that are currently available with mutual fund investments. In SWPs, a specific sum can be chosen by investors to automatically get withdrawn from their investments on a monthly basis and subsequently get credited in their savings accounts. SWPs will be a really good option if you are careful about the sum that you choose to withdraw every month, to get regular long-term sustained income. It is important to withdraw just three to four percent from the gains. You can enhance the regular income stream by selecting plans that are rooted to a specific percentage of accrued gains, like 60 percent or 74 percent. The rest of the money that remains will continue to earn compounding gains.

It is important for all investors to realize the drawbacks of dividends associated with mutual funds. It is time for you to take steps to opt out of that option, whether it is a new mutual investment or an older one.

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