Sudha wrote a comment a few days ago about the effect of Direct Tax Code (DTC) on dividends from equity mutual funds, and I’ve been meaning to do a post on it since then.
Currently, dividends from equity mutual funds are completely exempt, which means that there is no tax on them at all. Equity mutual funds are unique in this because equity shares are taxed using the dividend distribution tax, and so do debt mutual funds. This tax is collected from the company or the fund issuer, and not the investor, but reduces the money you get nevertheless.
With the DTC implementation, the dividend of an equity mutual fund will be taxed at 5%, and this will have to be paid by the mutual fund holder.
(Source: Direct Tax Code, Tax on Distributed Income, Chapter VIII)
The capital gains on these mutual funds will be taxed at redemption as well, so with the new DTC rule coming in, it’s better to buy the growth option of these equity mutual funds than it is to buy the dividend option.
Even without this option I’ve been in favor of putting money in growth option rather than dividend option because that allows your money to compound for longer, and helps it grow.
I constantly hear people talking about getting money from dividends to pay off some other expense like a insurance payment, or an ELSS payment, but that doesn’t make much sense to me.
It’s true that you “feel” that a payment was made without money going out of your pocket, but it’s your money regardless! Now, you have that much less invested in the market and reduced from your net worth.
On a semi related note, I know that a lot of people who have credit card debt are advised to start using cash instead of plastic because if you have to pay Rs. 1,000 in cash money it pains a lot more than if you just had to swipe a card. I can understand and appreciate this psychology, and I think something similar is at play when you can use a dividend to pay off an expense, but I can’t appreciate that, and certainly wouldn’t advise a friend to choose a dividend option for just this reason.
In any case, if nothing changes between now and when DTC kicks in – you should be aware of this 5% tax on dividends of equity mutual funds, and make a decision keeping it in mind.
There is no difference in the current scenario between dividend reivestment option and growth option, i.e. in terms of final redemption value when one sells. But in the dividend reivestment option, one keeps on booking tax free dividends and the new units bought out of this dividend increases the “cost of acquisition”. Thereby even a person sells before one year is over and some dividends are declared the captial gains would be lower (than the growth option). But with the new DTC recommending 5% tax on dividends, this option too would be redundent. We have to wait and watch whether this proposed tax (which is double taxation of the same income) will be implemented when DTC kicks in next year.
Thanks for this post.
Just mailed in the switches.
I must admit the div reinv option was psychologically very satisfying.
Even though it was one’s own money 🙂
Nice while it lasted.
Great, let’s hope that compounds to a huge amount for you in the years to come!
well for me equity mutual funds are always about investing for long term and one should take advantage of growth option to get their money grow rather than taking money out from it in form of the dividends.
My views exactly!
I would rather go in for a fund which would pay out high amounts of dividends in % terms of the NAV and choose its dividend reinvestment scheme.
Currently LTCG on Equity mutual funds is 0. When it will be taxed it wouldn’t be taxed at normal income tax rates, but anywhere from 10-20%. Either ways, 5% would be lower than 10-20%.
Tax arbitrage !! 🙂
Hmmm, this is not tax arbitrage – you will pay LTCG when you sell the bonds and will end up paying capital gains then, they might be reduced to the extent that the money is reinvested in more units, but that’s about it. It will not make it more advantageous to own dividend schemes.
Manshu, what about the dividend reinvestment option? that dividend does not come in the hands of the investor but is invested again in the fund. I believe DDT will continue to remain applicable on that. Isn’t it?
I didn’t come across any reference to that in the text , so I’m not sure; I’d expect the same tax to be deducted before applying that money to buying more units, but the fund houses do need to spell out the mechanics of how this will be done.
Great point though!
a very good point indeed but what I liked most is the card-cash example. Would recommend this article to my friends 😀
That will be awesome thanks!
Any idea when is this DTC kicking in?
It’s supposed to be effective from next financial year Mike, but there are several things that have to be ironed out still, so I don’t know if it really will be effective from next year or not.
Yes I myself never understood why ppl think dividend from MFs is free money?
I myself prefer growth option and for same reason.
Mental jugglery that keeps some people happy I guess.