After my last few posts I am getting a lot of enquiries from people as to what they should do about their schemes with dividend options now. Many are unclear about the tax and how will it be treated in their hands. In this post I wanted to demystify the dividends from equity MF and suggest ways about how you can deal with them.
To begin with let us understand how a Dividend option of an MF scheme is different from a stock. Any company, whose stock you hold, will pay you dividends from the profits that it makes in a quarter or year. Based on the amount of dividend paid the stock price will normally fall initially but may well rise later. In the case of a Dividend paying MF scheme, the dividends are being paid out from the assets held by the scheme. As some of these assets are liquidated the NAV of the fund will necessarily fall after a dividend is declared. Yes, it may rise again if the stocks in the MF scheme portfolio do well but it is fundamentally different from the stocks.
Let us now examine the taxation aspect of dividends before and after the budget. When a company declared dividends it was out of the profits where taxes have already been paid by the company. Therefore the dividend that investors received was tax free. In the case of equity MF schemes too they did not pay any holding tax and whatever dividend the investor got was again tax free in their hands. After the budget the situation remains the same for stocks but has definitely changed for MF schemes. These will now have to hold a tax of 10 % before distributing the dividends to the investors. This is the Dividend Distribution Tax ( DDT ) newly introduced in this budget. Remember that Debt funds always had a DDT of more than 28 % earlier and continue to do so.
How does this change things for you now? Well, for one you will have lower dividends for your equity MF schemes due to the DDT. Typically this will be 10 % lower. It will continue to be tax free in your hands. For example, I had invested 2 lacs in the dividend option of a Value Fund series NFO from ICICI. Every year I would get 15000 Rs dividend from this investment. All things remaining equal, the value of this dividend after the new DDT rule will be 13500. If an investor is depending on these dividends for passive income then he will need to get this shortfall from somewhere else.
In general Dividend option is not a good idea for equity MF now – note that companies pay tax on their earnings and this is reflected in the stock price and also the level of dividend they pay to their investors. Equity MF are investing in these companies and are again paying DDT. Finally when you redeem these investments you will again be charged LTCG tax at 10 %. It will be much better to just deal with the Growth option where you just pay LTCG tax when you redeem your units.
Let us now look at some classes of investors who are currently invested in these MF schemes and what they should do about it:-
- If you are in the active income earning stage of your life, there is no logic in having Dividend options for your MF schemes. Change all of them to growth. Even if you need the money you will be better off just redeeming some units as and when you need to do so.
- If you had chosen this option in order to do some explicit profit booking by the Fund houses then your concept was wrong. Fund Managers will churn their portfolios as and when required and these benefits will reflect in the NAV of your scheme. There is really no need to invest in the Dividend option for it. You should also change it to Growth option.
- People in the retired or FI state may have invested in these schemes as a means of getting regular income. Some Balanced funds have schemes where they distribute a monthly dividend. Note that all of these are subject to DDT now – so either you will get less dividend in your hands or the fund NAV will fall more if the same dividend is to be maintained.
Except in the last case, where some people may want a hassle free receipt of dividend as compared to redeeming units on their own, there is really no point in Dividend options of MF schemes now. In fact, with online redeeming being possible, anyone can sell units of MF schemes rather easily and I will definitely recommend that.
Short conclusion to the story – change all your MF schemes to Growth option right now!!