Do not invest in Dividend Schemes from Equity Mutual Funds

Budget 2018 introduced Dividend Distribution tax on dividend from equity mutual funds.

In one of my earlier posts, I had highlighted how mutual fund houses are misguiding investors and convincing investors to invest in dividend plans of mutual fund schemes.

Dividend schemes never made for a good choice in case of equity funds. In this post, we will look at the reasons. Additionally, with the introduction of Dividend Distribution Tax (DDT) on dividend from equity funds, the choice of the dividend option for regular income becomes an even worse choice.

You do not control the quantum of dividend, Fund Manager has discretion

Distribution of dividend and the quantum of dividend is purely fund manager’s discretion. Of course, they will try to meet the promises given.

However, if for any reason, dividend pay-out is reduced or skipped altogether, you cannot do anything. Of course, you can sell your units in the scheme.

Dividend can only be paid from the profits

As per the rules, dividends can be distributed only from the generated surplus (profits generated through investments).

Therefore, if the stock markets do not do well, the ability of the fund manager/fund scheme may be limited.

Introduction of Tax on equity mutual funds makes dividend option even worse

Budget 2018 introduced Dividend Distribution Tax (DDT) of 10% on the dividend paid from equity funds. This tax is applicable on any dividend distributed by equity mutual funds on or after April 1, 2018.

Please understand DDT is paid by the mutual fund house on investors’ behalf. So, in a way, the dividend is still tax-free in the hands of the investor i.e. investor does not have to pay any tax. However, the tax comes from your funds only.

Additionally, the DDT is also subject to a surcharge of 12% and cess of 4%.

The way DDT is calculated, your effective tax liability is way higher than 10%.

Let’s try to understand with the help of an example.

How is Dividend Distribution Tax (DDT) calculated for mutual funds?

Suppose you received Rs 100 dividend from your equity fund. To be able to shell out such dividend, the NAV must go down by 100/(1-DDT) = 100/(1-10%) = Rs. 111.11

This is taxation on gross basis.

DDT is effectively 111.11 X 10% =Rs. 11.11 (and not Rs 10, as most of us may believe)

Surcharge of 12% is charged on the DDT = Rs 11.11 X 12% =Rs. 1.33

Cess (4% from FY2019) will be charged on DDT and Surcharge.  Cess = 4%*(11.11+1.33)= 0.497

DDT +Surcharge +Cess = 11.11 +1.33+0.497 = Rs. 12.942

Therefore, for you to receive a dividend of Rs 100, the NAV of your scheme must go down by Rs 112.492.

The other way to calculate total tax is: 100/(1-DDT rate) * DDT rate * (1 + Rate of Surcharge) * (1 + Cess) = 100/0.9 * 10% * (1+ 12%) * (1+4%) = Rs 12.942

You get Rs 100. Tax is Rs 12.942. Total reduction in NAV will be Rs 112.942.

Your effective tax rate on dividend received is 12.942% (and not 10%). The difference is because the dividend is taxed on gross basis and due to surcharge and cess.

For like-to-like comparison with other income sources, the tax liability is 12.942/112.942= 11.46%. This means, out of Rs 100 paid by the AMC (reduction in NAV), only Rs 88.54 reaches your bank account.  The rest goes towards taxes. This will help you compare the tax rate on dividend with other sources of income. This Rs 88.54 received in your bank account is exempt from tax.

You could have gone for Growth option instead of the Dividend option

Under the dividend option, you get regular income in the form of the dividend.

Had you opted for Growth option under the same scheme, you wouldn’t get any dividend but you can always sell the units to generate the same level of income. You don’t have to wait for the fund scheme to declare dividend.

By the way, Long Term Capital gains from the sale of equity fund units results will be taxed at 10% from FY2019.

Let’s see which option is better.

You invest Rs 10 lacs each in Growth and Dividend option of the same MF scheme.

A few assumptions that we need to make.

1. You need an annual income of Rs 80,000 per annum at the end of each year. Assume there is no inflation.
2. You earn a constant return of 10% per annum in the scheme. Sounds quite non-sensical. Please play along. By the way, many investors expect much higher constant returns when they invest in equity funds. I could have used historical Sensex or Nifty data to demonstrate my point. However, a constant return will explain the point just as well.
3. The fund manager will pay a dividend of Rs 80,000 per annum. You will receive a dividend of Rs 80,000 per annum in the dividend scheme.
4. In the Growth scheme, since there is no dividend, you will have to sell the units to generate the same level of income (post-tax).
5. The NAV at the time of purchase is Rs 500 under both schemes.
6. Any capital gains resulting from the sale of units in the Growth or dividend schemes qualify for long term capital gains. The assumption is that no units will be sold before 1 year.
7. I have assumed that your total income is comfortably higher than the basic tax exemption limit.

Points to Note

1. Dividend on equity funds shall be subject to tax of 10% (in form of Dividend Distribution Tax). Please note tax is charged on a gross basis (discussed earlier).
2. DDT is paid by the AMC on your behalf. You do not have to pay any tax for the dividend received. You can think of DDT as TDS.
3. You can’t claim DDT (paid on your behalf by the AMC) even if your total income is less than the minimum taxable income.
4. Dividend comes from your money only.
5. When the dividend is paid, your fund NAV goes down by dividend per units plus taxes and cess.
6. The Long term capital gain arising from the sale of equity fund units is taxed at 10% (from FY2019). This rule is applicable for any sale made on or after April 1, 2018. However, the first Rs 1 lac of such gains is exempt from capital gains tax. We have seen the impact of tax on performance in an earlier post. In these calculations, we will assume that LTCG from other sales is in excess of Rs 1 lac so that LTCG is taxed at 10%.
7. Such tax will be subject to cess. Cess shall be 4% from FY2019.
8. Surcharge is not applicable on long term capital gains tax, unless your taxable income exceeds Rs 50 lacs.
9. If your taxable income excluding such long term capital gains from equity funds is less than minimum taxable income, the long term capital gains shall be reduced by such deficit amount. By, dividends are not accorded this relief. In these calculations, we have assumed that your annual income is way higher than the minimum taxable limit.
10. In the absence of such an assumption, the growth option will look like an even better option.
11. When you are selling MF units, your redemption proceeds comprise both principal and gains. Tax is paid only on the gains (and not the principal amount).

Let’s look at the performance.

Dividend option

Growth option

What can we infer?

1. Given the assumptions, growth option has done much better.
2. You are left with Rs 15.2 lacs at the end of 15 years under the Growth option. You would have only Rs 13.06 lacs at the end of 15 years dividend option.
3. In the absence of DDT and tax on LTCG, you would have had Rs. 16.35 lacs at the end of 15 years under both options. Therefore, taxes had an impact in both the cases. Just that the impact was lower in Growth option.
4. I have not considered the tax exemption of LTCG of Rs 1 lac from the sale of equity funds per financial year. Had we considered, the growth option would have given even better returns.
5. You can see the number of units remains the same under dividend option. On the other hand, the number of units keeps going down in the growth option. Of course, this is due to the example chosen.

Why has Growth option done better?

You may now have a question.

The rate of DDT and tax on LTCG is same. Why then do we have this difference?

There are three reasons:

1. A Surcharge of 12% is applicable on Dividend Distribution Tax. No surcharge on capital gains, at least as long as your taxable income does not exceed Rs 50 lacs.
2. On dividend, DDT is charged on grossed-up basis. Therefore, the effective tax rate is higher than 10%. It is 12.942%. For long term capital gains, the effective rate of tax is 10.4% (including cess, not including surcharge). If your income is above 50 lacs, surcharge is applicable even on capital gains. Therefore, if you are a high-income earner, do keep this aspect in mind. You may want to rework the numbers.
3. Now the most important bit, when you receive income in the form of dividend, the entire receipt is taxable. However, in the case of capital gain from the sale of growth option units, the redemption amount includes both principal and capital gains. Only the capital gain is taxed. And this affects compounding.
4. LTCG on equity funds is exempt up to Rs 1 lac per financial year. No such relief for Dividends from equity funds. Do note I have not considered this aspect in the calculations.

What should you do?

Please understand I am not saying that you should invest in Growth plans of equity mutual funds if you want to generate regular income in the immediate future.

Even Growth plan of an equity fund is a bad choice for regular income. Just that it is a lesser evil than the dividend option of an equity scheme.

In one of my earlier posts, I have discussed why Systematic Withdrawal Plan from an equity fund is a very bad idea.

The funds that you need to generate regular income in the immediate future should not be in equity funds in the first place.

A debt fund that invests in high credit quality securities and has low-interest rate sensitivity is a much better choice. In case of debt funds, you can choose between the growth and dividend option depending upon your tax slab (and now surcharge slab too) and the investment horizon.

For this post, I have not considered arbitrage fund as an equity fund (even though such funds enjoy same tax treatment as an equity fund). In specific cases, the dividend option from arbitrage funds may be a better choice than the growth option.

The post was first published in February 2018 and has been updated since.