Ashok chooses a dividend plan when making some investments under a mutual fund scheme. He feels that if he chooses a growth plan, he may not receive the periodic payments he prefers to manage his funding needs.
He also prefers to choose MF programs that declare periodic dividends. Mentally, he equates the dividend plan with the fixed deposit schemes of banks, where interest is paid periodically. Is it the right approach? What should be the basis for choosing a dividend plan or a growth plan?
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Generally, MF distributors encourage growth plans “if there is no need for regular cash flow”. Some funders even recommend it. But this may not be the right approach.
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Growth and dividend option
In the growth option, profits made by the program are reinvested into the plan rather than being paid out to investors. Because profits are reinvested in the program, the investor can profit on profits and thus benefit from compounding. In the dividend option, the profits recorded by the fund manager are distributed to the investor.
The distribution of dividends by an MF is not like the distribution of dividends by a company (to its shareholders). A company’s dividend distribution is made from the profits it makes. It shows the company’s profitability and how much of its profits it distributes.
When an MF pays dividends, the net asset value of the fund falls accordingly, and so does the investor’s outstanding investment.
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Instead of choosing a dividend plan, you can choose a growth plan and use the amortization facility for any periodic requirement. There are even systematic withdrawal plans available.
Taxation is different
Dividend and refund taxes are different. Following the abolition of the Dividend Distribution Tax in 2020, all dividend income can be taxed according to the income tax sheet under the heading ‘Income from other sources’.
TDS (tax deducted at source) also applies to dividends distributed by the MF program. Under the new rules, an MF must deduct 10 percent TDS under Section 194K if, when distributing dividends to investors, the total dividends paid to an investor during a fiscal year exceed ₹5,000. This can be requested when the tax return is filed.
For redemption, there is a tax on capital gains. This depends on the MF type and also on the duration of the investment. The short-term capital gains (STCG) holding period for equity funds is less than 12 months and less than 36 months for debt funds. Beyond this period, it is considered long-term capital gains (LTCG).
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STCG is charged 15 percent for the sale of units of equity-focused MF programs. In debt plans, it is charged according to the assessor’s tax plate.
LTCG tax on MFs (equity focused plans) is levied at 10 percent on capital gains exceeding ₹1 lakh. Debt-focused programs are charged 20 percent with indexing benefits.
take away
It is clear that a person can save tax by choosing a growth plan and use the payback opportunity instead of choosing a dividend plan. In a dividend scheme, the entire dividend receipt may be taxable, except for the TDS provision, while the tax on capital gains may be advantageous.
Also, the redemption can be made by the individual investor independently while the dividend is decided by the mutual fund.
Exceptional
Equity-linked savings plans come with a three-year lock-in period. Therefore, units cannot be used during this time. In this case, if a dividend plan is preferred and the fund also declares dividends during the lockdown period, it can be beneficial to the investor as it will increase cash flow. In all other cases, there is no need to choose a dividend plan.
(The author is a retired banker. The views expressed here are those of the author and are not investment advice.)
