Dividend or Growth Plans? It’s a no-brainer post budget

The 2020-21 Budget has done away with the dividend distribution tax (DDT) that funds have to deduct before distributing dividends to investors.

Instead, from 1 April 2020 dividends will be taxed in the hands of investors at their relevant income tax slab rates. 

What does this mean for mutual fund investors? 

Pre- and Post-Budget – what has changed for equity scheme investors:

• Growth plan

  • Nothing has changed for those investing in growth plans.

• Dividend plan

  • Earlier, dividends were tax-free in the hands of investors. The fund would, however, deduct a DDT of 11.65% before distributing dividends.
  • Now, DDT has been removed and investors will pay tax on dividends based on their income tax slab rate.
  • This will mean lower dividend tax burden than before for those in the 5% and 10% slab rates (under the new income tax regime).
  • This will mean higher dividend tax burden for those in the 15% and higher income tax slabs.

• Our recommendation

  • We have always preferred the growth over the dividend option in case of long-term investment products such as equity-oriented mutual funds (where equity exposure is 60% or higher).
  • The Budget tax tweaks have made the dividend option inefficient from a tax perspective too (except for those in the lower tax brackets).

Pre- and Post-Budget – what has changed for debt fund investors:

• Growth plan

  • Nothing has changed for those investing in growth plans.

• Dividend plan

  • Earlier, dividends were tax-free in the hands of investors. The fund would, however, deduct a DDT of 29.12% before distributing dividends.
  • Now, DDT has been removed and investors will pay tax on dividends based on their income tax slab rate.
  • This will mean lower dividend tax burden than before for all, except for those in the 30% income tax bracket.

• Our recommendation

  • While the tax burden on dividend plan investors (excluding those in the 30% bracket) will come down relatively, we don’t recommend the dividend option.
  • Investors requiring regular pay-outs can instead go for the far more tax-efficient SWP (systematic withdrawal plan). In a dividend plan, the entire dividend amount is taxed. In an SWP, however, only the capital gain is taxed. That is, the tax is imposed on the number of units sold multiplied by the difference between the NAV at which the units are sold and the NAV at which they were bought.
  • Let’s take an example. Suppose you come under the 30% tax bracket. You invest ₹10 lakhs in a debt scheme – dividend plan. At an NAV of ₹10, you are allotted 1 lakh units. Now, suppose the NAV per unit goes up to ₹11 in a year’s time.

When the fund declares a per unit dividend of ₹1, you receive ₹1 lakh as dividends. On this, you will have to pay 30% tax, that is ₹30,000.

Instead, if you had opted for an equivalent SWP of ₹1 lakh, then your tax liability would have been lower. You would pay a tax of 31.2% (30% slab rate plus 4% cess on it) only on the capital gains made. 

For the SWP, 9091 units @ ₹11 NAV would have to be sold off. The capital gains on the units sold would be ₹9,091. That is, 9,091 units multiplied by (₹11 minus ₹10).

On this, you would pay 31.2% tax which would come to only ₹2,836. This is far lower than the ₹30,000 tax paid on dividends.