Investing in dividend MFs for regular income? Think twice

Dividends sound exciting, not only in individual stocks, but also in mutual funds. A lot of people invest in mutual funds with dividend pay-out option to get some money periodically. What they miss out is the taxation on dividend mutual funds makes it less efficient than other mutual fund options. Moreover, they lose on compounding benefit.

“Finance Act, 2020 changed the way dividend income is taxed, prior to that, dividends received from mutual fund schemes were exempt from tax in the hands of the recipient. These modifications in regulations abolished dividend distribution tax (Tax deducted at source while distribution) and dividend income became taxable in the hands of the recipient. This regulation applies regardless of the option selected, pay-out or reinvestment,” said Vaibhav Porwal – Co-founder, Dezerv, a wealth-tech firm.

Knowing about dividend mutual funds 

Dividend mutual funds invest in stocks of dividend-paying companies and corporates issuing bonds and debentures. When the companies declare the dividends or interest income is paid on bonds and debentures, the AMCs pass it on to MF unitholders.

Three key reasons to avoid

1. Tax-inefficient: Dividend from mutual funds is taxed as per the applicable tax slab of the recipient. If someone falls into the 30% tax bracket, the applicable tax rate would be 31.2%. On the other hand, if you invest in the growth option of an equity or a debt mutual fund, you will get better post-tax returns. “LTCG on both debt and equity mutual fund enjoys preferred tax rates (10% in case of equity and 20% with indexation benefit in case of debt),” says Porwal.

2) Irregular cash-flow: Remember that dividend payment is not certain. The fund house doesn’t give you a guarantee that the dividends will be paid. The amount of dividend, if it gets paid, varies too. That said, you cannot rely on dividend income for your monthly expenses.

3) Impact on compounding: One needs to understand how dividend payment impacts the NAV in a mutual fund. After the dividend is paid, the NAV of the MF scheme gets reduced by the same amount. For example, if the NAV of a mutual fund is Rs 100 at the time of dividend payment, and the dividend pay-out is Rs 3 per unit, then the NAV will go down to Rs 97. Every time the dividend is paid, the NAV gets reduced by the dividend amount per unit. On the other hand, the NAV in the growth option of the same mutual fund scheme will keep growing.

“Recurring payout and resultant taxation lead to leakages. This can have an impact on the long-term compounding of the corpus. It is advisable to invest in the growth option of the Mutual fund schemes and investors seeking periodic cash flow are better advised to create a separate pool to meet the liquidity requirements,” he added.

Alternatively, you may start a systematic withdrawal plan (SWP) in your MF scheme, which will not only give you a regular flow of income at the prescribed date, but also will be more tax-efficient.

“SWP is similar to a regular redemption, entailing withdrawal of principal plus profits. You only pay tax on the capital gains portion (which is minuscule initially) and not on the principal component. As time passes, the capital gains portion increases but by then, the gains are treated as long term capital gains and taxed at a much lower rate,” pointed out Vishwajeet Parashar, Chief Marketing Officer, Bajaj Capital.