Who does not like to be rewarded for their efforts in some form or the other, dividend mutual fund schemes were positioned in a similar manner as well.
Dividend from mutual fund schemes were and still to a large extent even today seen as a form of reward for investing in a mutual fund or because your mutual fund scheme performed well and is passing back to you part of the profits earned.
In reality though, dividend from mutual fund schemes were always since beginning a process by which you would get your own capital as well as part of the profits your mutual fund scheme had earned.
What is a dividend paying mutual fund?
When you invest in mutual funds you get the following two options:
- Growth
- Dividend
The growth option means any appreciation the fund makes would be added to your valuation amount and will stay the same way until and unless you decide to withdraw.
The dividend option within itself too gives you further three options:
- Dividend pay-out
- Dividend reinvestment
- Dividend transfer
With dividend pay-out, you would get any dividend declared.
Whereas in dividend reinvestment, any dividend declared is reinvested back into the same mutual fund scheme that you hold.
Are dividend mutual funds a good idea?
Here’s why dividend mutual funds are a terrible idea:
- You pay tax on taking a part of your own capital back, equivalent of taking money out of your right pocket and putting in your left pocket and paying a tax on it.
- Dividend mutual fund schemes gradually erode your capital.
- They give you the impression of making a profit but that is not always the case.
- The taxation system on dividend received from mutual funds is not attractive at all for retail investors.
With a dividend mutual fund, the fund manager is always under pressure to create profits for investors.
This leads to the fund manager picking stocks he may not have otherwise picked.
For eg. If a particular sector or scrip is doing well or expected to do well in the short term, then the fund manager would be tempted to pick it since any appreciation in the scrip (hypothetically) would allow the fund manager to book profits and pass it on to the investors.
This ideally would not be the case with growth mutual fund schemes since the fund manager would have taken a longer view of the market which is highly recommended.
Additional reading: Click Here to read our complete review of Kotak Standard Multicap Fund
New tax rules on dividend received from Mutual Funds
Budget 2020 had introduced new tax rules for dividend received from mutual funds.
Dividend Distribution Tax (DDT) has been abolished.
- Earlier dividend received from mutual funds was tax free in the hands of the investor since tax for the same was already paid by the mutual fund in the form of Dividend Distribution Tax (DDT).
- The issue with such a system was that the dividend was received by investor but paid by the mutual fund company which did not make sense.
- With a fixed Dividend Distribution Tax rate, small and big investors alike ended up paying the same tax rate irrespective of the dividend amount.
Under the new rule now, effective 1st April 2020 onwards, dividend received from mutual funds is now added to investors income and gets taxed according to the investors tax bracket.
For example lets say Mr X received dividend Rs 10,000 on 25th August 2020 which is more than 5,000 he will pay a TDS of Rs 750 on the dividend income.
7.5% of 10,000 is 750, therefore he would receive Rs 9,250 which would then further be added to his taxable income for the financial year.
The standard rate for TDS on dividend income exceeding 5,000 is 10%, however the government has reduced that to 7.5% from 14 May 2020 to 31 March 2021 in light of Covid-19 crisis.
Form 15G/15H
Any resident individual having an estimated annual income below exemption limit and receiving dividends can submit form 15G to the mutual fund AMC paying dividend.
In the same manner, any senior citizen without any taxable income can submit form 15H to the mutual fund AMC paying dividend.
Doing the above, helps both the resident individual and the senior citizen to receive dividend without TDS.
Why does the price of mutual funds drop when you get dividends?
Let’s suppose the NAV of a particular mutual fund scheme is 15.
The fund decides to book profits and declares a dividend of Rs 5.
The NAV of the fund therefore then comes down to 10.
This is not the case with growth mutual funds though which is why you can notice a difference in NAV’s of a growth and dividend option of the same mutual fund scheme.
An example of NAV dropping frequently with dividend declaration can be seen in the image below.
New name for Dividend Mutual Funds
The regulator SEBI, has declared that from 1st April 2021 onwards dividend plans of mutual funds would be renamed as follows:
- Dividend pay-out plan would be renamed as ‘Pay-out of Income Distribution cum capital withdrawal option’
- Dividend reinvestment plan would be renamed as ‘Reinvestment of Income Distribution cum capital withdrawal option’.
- Dividend transfer plan would be renamed as ‘Transfer of Income Distribution cum capital withdrawal option’.
This name change has been necessitated because so far investors were under the belief that dividends received by them were a part of their profits when in fact, they were also a part of their capital too.
Basically, investors were paying tax on taking back their own capital in the form of dividends.
Additional reading: Click Here to read our complete review of Principal Emerging Bluechip Fund
How you were paying tax on receiving back your own capital?
Suppose a mutual fund scheme declares a dividend of Rs 5 when its NAV is 105.
Now the NAV of the same fund is therefore 100.
The NAV of the fund appreciates up to 102 and that is when you invest too.
The NAV further appreciates up to 105 when the fund declares a dividend of Rs 5 again.
Now you the investor, will receive not just Rs 3 of the profits but also Rs 2 which is your own capital.
So far though retail investors were believing that they were receiving profits as dividend when in fact they were also receiving their own capital back in the form of dividends.
You therefore ended up paying tax not just on your profits (Rs 3) but also on your own capital (Rs 2) which was a lose-lose situation for you.
The situation would have gotten worse in case you were in the highest tax slab of 30%.
Under the new rules effective from 1st April 2021, mutual fund companies would have to divide declared dividend into Income Distribution (Profits) and Capital Distribution (Invested amount) which would be showcased in your Consolidated Account Statement.
Can I get monthly income from mutual funds?
The most common reason for investors to pick dividend option mutual funds is to get a monthly source of income from mutual funds.
Even though there’s nothing wrong in this goal, what’s wrong with it though is the plan to achieve this goal.
Instead of depending on dividends for monthly income from mutual funds, instead investors should in fact use the Systematic Withdrawal Plan (SWP).
In a systematic withdrawal plan, you first accumulate the final desired amount with lumpsum or sip mode.
Once you have this desired amount, you can withdraw either a fixed or variable amount monthly.
Difference between Stock Dividends and Mutual Fund Dividends
There is a very common misconception among retail investors that stock dividends and mutual fund dividends are same.
This misconception has contributed to several naïve investors investing in the dividend option of a mutual fund in the hope that the profits earned by the mutual fund scheme would be paid back to them.
Stock Dividend
A stock dividend is given out of a company’s earnings, usually once a year.
There is no compulsion on the companies as such to declare dividends each year though.
Companies may not declare dividends for the following reasons:
- To reduce debt or a portion of debt
- To reinvest it in the business
- To keep it aside for future business purposes.
Mutual Fund Dividends
A mutual fund dividend is declared only when you pick the ‘dividend’ option and not when you pick the ‘growth’ option.
There is no guarantee that the dividend will be declared though.
The dividend declared could be either weekly, monthly, half yearly or yearly.
Unlike a stock dividend, a mutual fund dividend can be declared from the capital itself, meaning your own money could be given back to you for which you would be taxed.
The very fact that dividend mutual funds ever existed in their old format or that they even exist today is rather surprising.
If you are still invested/investing in them then you need to get out as soon as possible keeping in mind exit load, tax implications, etc.
For portfolio enquiries, email us with your doubts at info@themutualfundguide.com
