Mutual fund dividends need to die. They should be abolished and replaced by specially designed withdrawal plans that investors can choose according to their needs. That sounds like a radical suggestion but actually, it's not. Because financially, there is already no such thing as dividends in mutual funds. What are called dividends are exactly what I'm suggesting--withdrawal plans. Except that currently, they are misnamed dividends and are arbitrarily structured by mutual funds to suit their own marketing needs.
The so-called dividend in mutual fund serves no purpose except as an artificial and misleading marketing tool. Worse--starting this year, new taxation rules mean that equity fund dividends also lead to investors paying more tax than they should. If you have opted for the dividend option of a fund, you are almost certainly paying needless tax.
I'd explained the basics of dividends in the first part of this column but apparently, many investors are unconvinced about their uselessness so let's delve a little deeper. The dictionary definition of dividend is, 'a sum of money paid regularly (typically annually) by a company to its shareholders out of its profits (or reserves).' Investopedia says, 'A dividend is a distribution of a portion of a company's earnings.' The Wikipedia article starts with, 'A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits.'
These (and other) definitions all point to the same thing, that when companies make a profit, they bring some of it back in the business, and distribute the rest to shareholders. Obviously, the management of the company has a choice in the matter. It's up to them how much (if any) dividend they distribute. There are plenty of companies that distribute very little or none of the profits as dividends, for a variety of reasons.
Absolutely none of this applies to mutual funds. In a mutual fund, ALL the profits belong to investors, except for management expenses of up to about 3 per cent. Whether the money comes to you as dividend or as withdrawal, there is no difference, except for the effect of taxation. As I'd explained last week, if the value of your investment in a mutual fund is Rs 1 lakh, and then the fund gives you Rs 5,000 dividend, the value of that investment will be reduced to Rs 95,000. In debt funds, what you receive is actually Rs 3,558 because the debt fund would withhold 28.84% of the dividend and pay that as tax. In equity funds, there was no such tax till this year. Now, even in an equity fund, there's a 10% tax. Accounting for the surcharges, you will get Rs 4,353 as dividend while your investment goes down by Rs 5,000. Thus, it makes no sense to opt for a dividend plan.
But what if you need a regular income? The answer is simple--instead of opting for the dividend plan, you should opt for the growth plan and just withdraw a certain amount regularly. The tax incidence is likely to be lower because in dividends, the entire amount is taxable, but in a withdrawal, only the gains part is taxable.
In fact, some older investments are getting an even worse deal. Once upon a time, a method of investing called 'dividend reinvestment' was popular because it led to lower taxation. Now, it actually destroys your money because of the tax on dividends. There's a 10% tax on both long-term capital gains and dividend. However, the tax on capital gains comes into play only when you actually sell your investment. The tax gets deducted by the mutual funds at source every time a dividend is paid out or reinvested. In effect, in the reinvestment option, your money keeps getting reduced. Even though the percentage of tax on capital gains is the same as dividend, your eventual returns will be severely impacted because the dividend tax constantly reduces the amount available for further growth.
The alternative I'm suggesting is simple. Currently, there are Systematic Withdrawal Plans (SWPs), in which investors can specify a certain amount that is withdrawn automatically every month and credited to their bank accounts. These are almost good enough, provided you take care to withdraw only up to 3-4% of the gains. From the point of view of sustainable long-term income from funds, this can be improved upon by having plans that are keyed to a certain percentage of gains, say 50% or 75%. That would leave the rest for further compounding.
Either way, it's time that this dividend fiction is recognised as such, and an end put to it.