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Mutual fund dividend plans are a harmful option

Regardless of the changes in this budget, dividend plans of equity mutual funds were always a bad choice for investors

Mutual fund dividend plans are a harmful option

The abolition of the Dividend Distribution Tax (DDT) and the shifting of equity and equity mutual funds dividends to the investors' taxable income in this budget was a long-overdue improvement in the taxation structure of investments. If dividends are to be taxed at all, then they should be part of the taxpayer's income. In the DDT arrangement, tax is deducted by the company or mutual fund paying the dividends at a constant rate that is applicable to everyone. Because of this, small investors and retirees getting small amounts as dividends end up paying the same tax as rich individuals and businesses with much higher dividend incomes.

Under the new arrangement which comes into force on April 1, there is no deduction of tax by the payer. There is a deduction of TDS but like any other TDS that is refundable if it's higher than your taxability. The net impact is that dividends get added to a taxpayer's income and effectively get taxed according to the tax bracket that the taxpayer comes under.

However, this change has roiled some equity mutual fund investors who are heavily invested in dividend plans of mutual funds and who come in the higher tax brackets. Up till now, they were paying DDT at 10 percent plus surcharge (effectively 11.648). Now, those who are in the higher income tax slabs will have to pay that much more tax on dividends. My simple answer to these investors is that you are doing it wrong anyway. DDT or no DDT, no one - absolutely no one - should have invested any money in the dividend plans of mutual funds. Instead of complaining about tax, just redeem your investments from dividend plans and shift it to equivalent growth (non-dividend) plans.

This is not a new idea for those who have been reading my column here. 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 definitions all say essentially the same thing: when companies make a profit, they bring some of it back in the business, and distribute the rest to shareholders as dividends. Obviously, the management of the company has a choice in the matter. There are plenty of companies that distribute very little or none of the profits as dividends, for a variety of reasons.

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. If your investment in the dividend plan of a mutual fund is worth Rs 1 lakh and then you get Rs 5,000 as dividend (without considering tax), then the worth of the investment will be reduced to Rs 95,000. Effectively, it's just a withdrawal of your money. It is NOT dividend in the sense of a company dividend.

Your choice of whether to invest in the dividend plan of a mutual fund or the growth plan should only be dictated by taxation. On that basis, you should have been in the growth plan before this budget, and the same after this budget. If you need regular income from your mutual fund investments, just withdraw the amount you need regularly. If you do that, you'll end up paying much less tax for the same amount, because the withdrawals will be subject to capital gains tax, not income tax.

Regardless of the changes in Budget 2020, the only reason for choosing dividend plans is if you would like to pay more tax than you need to. Don't do it.