Mutual Funds: With Tax on Dividends, The Choice between Growth and Dividend?

The Union Budget 2020 changed the way how dividends from mutual funds will be taxed. The following are the changes.

1. Till FY 2020, dividend from mutual funds was exempt from tax in the hands of the investor. However, before paying the dividend to you, AMCs used to deduct Dividend Distribution Tax (DDT) before paying such dividend to you. The effective impact of DDT was 11.46% for equity funds and ~27.97% for debt mutual funds. DDT was the same for everyone, irrespective of your income levels. There was no way for you to get tax credit against the DDT.
2. From FY2021 (April 1, 2020), the Dividend Distribution tax will be done away with. The dividend will now be taxed in the hands of the investor. Such dividend will be taxed at your marginal income tax rate.
3. If the AMC (mutual fund company) pays you a dividend of over Rs 5,000 in a year, the dividend will be subject to a TDS (tax deduction at source) of 10% (Section 194K). However, this is not lost money. If excess TDS has been deducted, you can claim it at the time of filing ITR for the financial year. For NRIs the TDS shall be 20% without any threshold (Section 196A).
4. Capital gains from mutual funds will NOT be subject to TDS. This is only for residents. Capital gains for NRIs have always been subject to TDS. That remains.

How Dividends and Capital Gains from Mutual Funds will be taxed?

Here is how capital gains and dividends from mutual funds will be taxed from April 1, 2020.

Clearly, the high income earners and rich people won’t be very happy with this. Now, their dividends will be taxed at 42.7% (for those earning more than Rs 5 crores in a year). However, they can go with Growth options in various MF schemes. In the growth option, tax rates are much lower and are the same irrespective of income levels (ignoring surcharge and less) except for STCG in debt mutual funds.

For the others, it is a favourable move. You can choose between growth and dividend as per your tax slab and potentially pay lesser tax than would have implicitly paid in the form of DDT.

If you must decide between dividend option and the growth option, what should you choose?

As I mentioned in my earlier post on dividend and growth options,

If the tax regime provides favourable tax-treatment to one kind of income (capital gains or dividends), you must invest in a more tax-friendly option.

If capital gains get better treatment, Growth option is better.

If dividends get better tax treatment, Dividend (or reinvestment) option is better.

Which is better now? Let’s find out.

Debt funds for Less than 3 years  (STCG)

Such capital gains qualify as Short term capital gains and are taxed at your marginal income tax rate.

If you have invested in a debt mutual fund for a short term (for less than 3 years), you can be indifferent between the dividend and the growth option. In both the cases, you will have to pay tax at your marginal income tax rate.

In fact, the dividends are subject at TDS at 10%. Consider a scenario where TDS is deducted in April 2020. You will file returns in July 2020 and the refund, if any, will come after another few months. If your marginal tax rate is more than 10%, you might still be fine with the TDS since the tax had to be paid anyway. You could have tinkered around with the timing of tax payments though.

Remember, if you invest in Dividend-Reinvestment option, the dividend will still be subject to TDS and then re-invested.

In my opinion, Growth is slightly better, because of TDS issue with dividends.

Winner: Growth

I have not considered the scenario where you are anticipating jumps through the tax slabs due to the increase in income or due to the quantum of capital gains. I mention this because your marginal rate may be different in different years. Let’s say if you were to make STCG of 6 lacs in growth option if you were to hold the investment for about 3 years. In the growth option, the entire gain or income (Rs 6 lacs) will come at the same time i.e. the time of redemption. It is possible that, in case of dividend option, the gains would have been spread out. Let’s say Rs 2 lac in each of the 3 years.

You need to see the distribution of income across the years in the form of dividends helps you reduce your tax liability.

Debt funds for More than 3 years (LTCG)

This one is a bit tricky but also actionable. Long term capital gains in debt funds are taxed at 20% after indexation. Now, we don’t know upfront what the levels of indexation will be over the years. You can only tell this in hindsight.

Therefore, it is difficult to figure out what we compare tax on dividend against. For the sake of the analysis, let’s say the effective tax after indexation will range from 10% to 15%.

So, if you are in 0% or 5% tax bracket, you can opt for the dividend option and reduce capital gains tax liability (which will be taxed at a comparatively higher rate). Be mindful of the TDS on dividend and its impact of your cashflows.

If you are in 10% or 15% tax bracket, the answer is unclear but growth is a winner because there is no TDS complication.

If you are in 20%, 25% or 30% or even above (due to surcharge and cess) tax brackets, you are better off in the Growth option.

There will be instances where you are unsure about the holding period. Up to 3 years or more, you don’t know at the time of making an investment. What do you do in such cases? On the basis on numbers, growth will be a winner here except for 0% and 5% brackets.

For 0% or 5% tax brackets, dividend remains a better. However, you must note that not all the income will be paid out at dividend. It is possible that you have gains even after dividend is being paid. You will have to pay LTCG or STCG (as the case may be) when you redeem. An additional point to note is the LTCG can only be adjusted against the minimum exemption limit of Rs 2.5 lacs (or 3 lacs or 5 lacs) as the case may be. Once your income breaches the limit, the entire LTCG is taxed at LTCG tax rate. If you fall in 0% or 5% tax bracket, your LTCG in debt funds will still be taxed at 20% after indexation. Therefore, to avoid higher tax in such cases, you can sell your units before the completion of 3 years and buy those back after a few days. Essentially, do not let your gains become LTCG.

Equity Funds for less than 1 year (STCG)

You shouldn’t be investing in equity funds for less than a year. If you exit before 1 year, most funds will also have exit loads. Frankly, for this section, I must write “Not applicable”.

Still, for the sake of completion, I will put down the threshold.

STCG in equity funds is taxed at 15% (before cess and surcharge).

Therefore, if your marginal tax rate is less than 15%, you are better off in dividend plans

If you are 20% or higher, you are better off in growth plans.

You must remember, investing in dividend plans does not mean you will avoid capital gains altogether. Dividend option will just reduce your taxable capital gains.

Equity Funds for more than 1 year (LTCG)

LTCG is equity funds is taxed at 10% (before cess and surcharge). However, first Rs 1 lac of Long term capital gain is exempt from tax.

There is no such relief for the dividend.

Therefore, in my opinion, growth is a better option for everyone. The size of your portfolio and quantum of potential dividends or capital gains will affect the choice.

However, your requirements may come in many permutations and combinations.

If you are in 0% or 5% tax bracket, dividend is a better option. However, this answer can change depending on your quantum of expected dividends or capital gains.

If you are in 10% or higher tax brackets, growth is a clear winner.

Additional Points to Note

1. I answered the above question purely from taxation point of view. However, as investors, we need to look at the issue in a practical manner too.
2. You invest in equity funds for growth in portfolio value. If you opt for dividend scheme and do not re-invest the dividends, the power of compounding may be compromised.
3. Dividends are not guaranteed. The quantum and timing of the dividend is fund manager’s discretion. Since dividends can only be paid from the surplus generated, the fund manager’s ability to distribute dividends can be compromised during market downturns.
4. I have read at a few places where authors have advised the investors should opt for Growth option of equity funds and run systematic withdrawal plans (SWP) to generate regular income. They say so because dividend taxation has become adverse for those in 20%, 25% or 30% tax brackets. Yes, it has but please ignore such ideas. Relying on dividend from equity funds was never a good idea and it remains that way. Relying on SWP from an equity fund was always a bad idea and it remains that way.
5. If you must do an SWP for regular income, you must run it from a debt mutual fund.
6. Dividend is like interest income now. Dividend is announced on all the units. Once the dividend is announced, you must pay tax on the entire dividend at your marginal tax rate. When you sell units in the growth scheme, your redemption amount will have both capital gains and principal. You will have to see if that changes something for you. This can be a decision parameter when you are in 20% bracket or higher and are unsure about the holding period and the quantum of redemption you will need to make.
7. In my opinion, when you are unclear, go with the Growth option.