It was pointed out to me that my entire mutual fund portfolio is comprised of growth options. This lead to a lengthy and interesting discussion about the mutual fund dividend option. This discussion made me aware of the misconception people have about the dividend option.
When I started investing in mutual funds, I read a lot about growth and dividend options. Since then growth option just became a default for me. So, why is it better to stay away from the mutual fund dividend option? The dividends paid are not an extra benefit. In reality, dividend results in less appreciation of Net Asset Value (NAV). The dividend is also marketed as being a tax-free income. But you might end up paying more taxes. The fund house distributes the dividend after deducting the Dividend Distribution Tax (DDT). The dividend option being a source of regular income is also a myth. The fund house is not bound to distribute dividends. In cases when fund’s earnings are negative or below a certain level, there might be zero dividends distributed.
What is Mutual Fund Dividend Option?
When you invest a certain amount in a mutual fund, you have two options. Growth option and dividend option, the dividend option with reinvestment being just a repackaged dividend option.
In the dividend option, a certain portion of the profit made by the fund is distributed among the investors as a dividend. This dividend can be on a monthly, quarterly, half-yearly or yearly basis. The profit comes from the dividend or interest of securities held by the fund, or the capital gain made by selling some of the securities held.
There are many myths which are propagated about mutual fund dividend. The myths are:
- The dividend received is an extra benefit over and above the growth of our investment. Just like the dividend offered by stocks.
- The dividend received is tax-free.
- The mutual fund dividend option works as a source of regular income.
Clearly understanding the truth behind these myths will enable you to make an educated decision.
Is the Dividend Received an Extra Benefit like Dividend of Stocks?
I have seen a statement being made by a lot of people. They boldly say, “just like stocks give you a dividend, you will also get a dividend from the mutual fund”. This statement cannot be any more wrong. The reason why they make this statement is either they don’t understand it or they are simply lying.
In the case of a dividend-paying stock, the company distributes a part of its profit as dividends. No negative effect on the value of stock occurs due to dividends. Declaration of dividend even increases the market valuation of some stocks.
On the other hand, a mutual fund may or may not invest in dividend-paying stocks. If the mutual fund earns a dividend, in case of growth option reinvestment of this dividend increases the value of your investment. But if the distribution of dividend occurs, the value of your investment does not increase. All the interest and dividends earned and any capital gain made constitute the profit of a mutual fund. Your investment grows even slower if the distribution of the entire profit occurs.
If you have a mutual fund with an NAV of Rs. 10 per unit. In the case of reinvestment of profits (growth option), let us assume the NAV becomes Rs. 16 per unit. But, in the case of dividend option Rs. 4 is distributed as dividend and the value of NAV becomes Rs. 12 per unit.
Thus, in reality, you do not receive any extra benefit. You simply trade long term gain for immediate money. You can verify this by comparing the NAV of growth and dividend option for any mutual fund.
Is Dividend from Mutual Fund Tax-Free?
This is the most used selling point of the mutual fund dividend option. But this can only be categorized as misinformation at best. The taxes are not paid by the investor himself. But, he receives the dividend after the deduction of the dividend distribution tax. It is the same as calling the maturity amount of a fixed deposit tax-free, after TDS (Tax Deducted at Source).
Whether direct or indirect, you pay taxes in both the options. But, which option is better in regard to taxes? To answer this we have to look at the following:
- Dividend distribution tax on equity and debt mutual funds.
- Long term and short term capital gains tax for equity and debt mutual fund.
The first point applies to dividend option and second to growth option.
The dividend distribution tax for a debt fund is 10%, and for an equity fund, it is 25%. The capital gains tax is slightly more complex:
- In the case of equity fund, the tax on short term capital gains (less than 1 year) is 15%. The tax on long term capital gains (more than 1 year) exceeding Rs. 1,00,000 is 10%. This means that long term capital gains up to Rs. 1,00,000 are tax free.
- In case of debt fund, STCG (less than 3 years in this case) are added to your income and you pay income tax on entire income. The tax on LTCG (more than 3 years) is 20% after adjusting for inflation.
This means that the dividend option provides a tax benefit only for short term capital gains. In the case of debt fund, even this becomes false if your income is below 30% income tax slab.
So, the dividend option turns out to be not so tax effective.
Does Mutual Fund Dividend Option provide a Regular Income?
The dividend option is usually sold as a source of tax-free regular income. We have already busted the myth of it being tax-free. Yet two concern remains.
- Is a mutual fund dividend option really a source of regular income?
- If someone wants regular income from a mutual fund. Is there a better option?
Dividend payout is usually advertised as being a regular occurrence. But, a dividend is not the right of an investor. Fund houses are free to determine the amount and date of dividend payout. During periods of upward trends in stock markets. The dividend is usually paid regularly. But, if the fund witnesses a low or negative growth. The fund house may not declare any dividend.
So much for that income being regular, right. A better alternative can be a Systematic Withdrawal Plan (SWP).
An SWP allows the withdrawal of a predetermined amount on regular intervals from a mutual fund. This can give you tax benefits as well as the benefit of wealth creation.
The amount is withdrawn by selling some of the units. Thus this does not compromise the benefit of compounding. And, if the fund is more than a year old, it also gives tax benefit. I can demonstrate the tax benefits by using a simple example. We consider the SBI Blue Chip Fund growth option with SWP and dividend option. You receive a sum of Rs. 20,000 per month from both funds. The entire investment was made on 10 April 2017. Withdrawal and dividend are being received from April 2018 on the 10th of each month. Let’s analyze the tax paid for the financial year 2018 – 19.
You pay zero tax in SWP and Rs. 26666.76 in the dividend option.
What Does All This Mean?
This means that:
- The dividend you receive is not something special, and this compromises the benefits that compounding can provide.
- The mutual fund dividend option is not tax-free and in majority cases, you end up paying more taxes.
- The dividend is not guaranteed and it is not a reliable source of regular income.
- The SWP facility in the growth option provides a much better alternative.
All these factors demonstrate that the mutual fund dividend option is not as beneficial as people think it is. Most of the benefits that are advertised turn out to be myths on deeper analysis. Overall you will do yourself a favor if you stay away from the mutual fund dividend option.
Dividend Reinvestment Option
I always make it a point to use professional language, even if I am criticizing a financial product. But, when it comes to the dividend reinvestment option, I can’t help it. This product is nothing short of a joke. Just like the growth option, the reinvestment of the profits made by the fund occurs in this option too. But, this is done in a way that is nothing short of ridiculous. First, the fund house declares and distribute dividend after deducting dividend distribution tax. Then your dividend is used to buy new units of the same fund.
This process gives a unique benefit of paying taxes twice. First, dividend distribution tax is deducted, and when you sell the units you pay capital gains tax too. You can make direct contributions to various relief funds if you want to help the government. The method of paying taxes twice on a single investment is not an effective way to help the government.
Have some pity on your finances, and never buy a dividend reinvestment option.
Who Should go for Mutual Fund Dividend Option?
If you are investing in an equity mutual fund for less than a year. As in that case, the capital gains tax is 15%, and the dividend distribution tax is 10%. But, I would never suggest anyone go for an equity-related product for such a short duration.
The second case can be if you are investing in a debt fund for less than 3 years, and your income puts you in a 30% income tax slab. In this situation, the capital gains tax is the same as your income tax, i.e. 30%. While the dividend distribution tax is 25%.
In both these situations, the dividend distribution tax comes out to be less than the capital gains tax. The term of investment is also small, so compounding does not play a very major role. Someone satisfying one of these conditions can opt for a dividend option.
For everyone else, I would recommend Mutual Fund Growth Option.