When you invest in Mutual Funds you usually have to choose from following three options:
- Dividend Reinvestment
For a new investor first selecting the mutual fund and then selecting of the above 3 options this may be overwhelming. In this post we tell you why you should opt for Growth option while investing in Equity or Equity oriented Mutual Funds.
- 1 Reason 1: Growth Plans are more Tax efficient than Dividend Plans
- 2 Reason 2: Long Term Capital Gains (LTCG) is Taxable when gains are more than Rs 1 Lakh
- 3 Reason 3: Compounding Effect for Wealth Creation
- 4 When People use Dividend Plans?
- 5 Tax Efficient way to Regular withdrawals?
- 6 What should you do?
- 7 Equity Mutual Funds: Growth Vs Dividend Option?
Reason 1: Growth Plans are more Tax efficient than Dividend Plans
Budget 2018 has introduced long term capital gains tax of 10% on equity and equity based mutual funds. Along with this it also introduced 10% dividend distribution tax (DDT) on dividends given be equity mutual funds. Though both seems equal but as they say Devil lies in details. Dividend Distribution Tax on Equity Mutual Fund Dividends are 12.942% (not 10%).
You might be thinking how the DDT is 12.942% even when the Budget notification says its 10%. Below is the calculation:
- DDT is 10%
- DDT Surcharge is 12%
- Health & Education Cess of 4%
- DDT = 10% * (1+12%) * (1+4%) = 11.648%
Now DDT is charged on the concept of “Grossing Up”. We would give an example to make the concept more clear.
Suppose the investor receives Dividend of Rs 100 from his equity fund.
As the fund has to deduct DDT before paying dividend. So for paying Rs 100 dividend, the actual dividend was Rs 111.11 (100/(1-10%))
- So the DDT was 10% of Rs 111.11 = Rs 11.11
- Surcharge @ 12% = Rs 1.33 (11.11 * 12%)
- Health & Education Cess @ 4% = Rs 0.497 (4% *(11.11+1.33))
- So the total deduction becomes DDT + Surcharge + Cess = Rs 12.942 (11.11 + 1.33 + 0.497)
If there was NO tax the investor would have got Rs 112.942 but after Dividend distribution tax, the investor only receives Rs 100
This means he loses Rs 12.942 as tax. Hence the tax rate for DDT comes out to be 12.942% where as its only mentioned as 10%.
In comparison the Long-Term Capital Gains is taxed at 10.4% (including 4% health & education cess)
So for any equity mutual fund investment, Growth Option where Long-Term Capital Gains would be applicable is much more tax efficient than Dividend Plan (where DDT would be applicable).
Do remember that Dividend distribution tax is paid by the fund house before distributing dividends to its investors. The dividend received by investors is tax-free in their hands.
Reason 2: Long Term Capital Gains (LTCG) is Taxable when gains are more than Rs 1 Lakh
As budget 2018 states the LTCG on equity mutual funds are applicable only after the gains in a financial year is more than Rs 1 Lakh. So if you have gains of Rs 50,000 the entire amount would be tax free while in case you have Rs 2 lakh capital gains, still only Rs 1 lakh would be taxed. So even on gains on Rs 2 lakhs, the tax would be Rs 10,400.
However, if you had invested in Dividend plan, there is NO exemption limit and entire dividend is subject to DDT.
Reason 3: Compounding Effect for Wealth Creation
Growth plans are more suited for long term wealth creation. Why? This is because dividends received are non-substantial most of the time and hence used in the regular day to day expenses. Since there is regular pay out there is no impact of compounding. However in case of growth plans the returns get compounded year on year and there is substantial wealth creation in the long run.
When People use Dividend Plans?
There are 3 reasons why people subscribe to dividend plans:
Lack of Awareness: Some people are not aware about Growth Vs Dividend plan and select something randomly.
For regular income: Some investors have a misconception that dividends from equity or balanced funds can be used to generate regular income. Unfortunately, its not true and regular dividends are only possible if the fund generates regular profit. While this may be sustainable in regular bull market but a bit of correction in the market and this regular dividend would vanish.
For booking profits: There are investors who choose dividend plan as it helps to book regular profit without them having to redeem funds. This may be good strategy but needs careful planning about the dividend received.
Tax Efficient way to Regular withdrawals?
As we see that Dividend Plans of equity mutual funds are inferior to their growth counterpart but in case you still want to replicate dividend plan for regular income or profit booking we have two tax efficient ways for you.
Redeem when you want to: This is especially true for people looking to book profit at regular intervals. Just redeem partially when you want to!
Use SWP (Systematic Withdrawal Plan): This is for people who want to use fund for regular income. You can set-up SWP which would pay you regular amount every month. This is much tax efficient way of generating regular income. But remember using Equity or Equity based balanced fund for regular income is not a good idea as correction in market would heavily dent your portfolio.
What should you do?
In case you have invested in dividend option of equity mutual funds and if the investment is from more than 1 year, switch to growth option before March 31, 2018. In case its less than 1 year wait for it to complete 1 year and switch slowly to Growth plan such that the long-term capital gains is less than Rs 1 lakh. Also if you are at a loss (due to recent market correction), you can switch even if the investment has not completed 1 year
Why you should wait for 1 Year before switching? Switching is considered as redemption from one fund and investment in other. Since its redemption, this involves concept of capital gains. If the investment is less than 1 year, the gains are treated as Short Term capital gains and taxed at 15.6% including cess while the Long-Term gains are taxed at 10.4%.
Equity Mutual Funds: Growth Vs Dividend Option?
With Budget 2018 proposing Long term capital gains and dividend distribution tax on equity mutual funds, growth option is the way to go for their more efficient tax treatment and wealth creation in the long run.