Sunday, February 21, 2016

Debt funds: How dividend is taxed

Mutual funds carry wide basket to fulfill diverse needs of investors. While equity oriented funds come with promises of high growth, they carry risk in the proportionate manner as well. The debt funds offer predictable returns with investors not needing to lose their peace of mind in times of volatility. 

Yet, taxation in the case of debt funds is largely least understood. 

Dividend distribution is the key attraction of most of the funds and a possible way 
for wealth creation. The investors do not need to run after their charter accountants to figure out their tax liability at least on dividends received. The reason is simple that there is no tax on dividend received by an investor. But investors at the same time should not ignore the taxation on dividend on debt funds for the simple reason that may affect their anticipated returns on the funds.

Even while a unit holder is exempt from tax on dividends received, the fund house has to pay a dividend distribution tax (DDT) before distributing this income to its investors. So, DDT is deducted by the asset management company prior to disbursal of dividends. The DDT is applied at the rate of 25 per cent, which in the past was 15 per cent. In addition there is a 10 per cent surcharge along with an education cess of three per cent. 

Thus, the effective DDT comes at 28.33 per cent. And, since the fund house deducts the amount from the corpus, the net asset value of the fund correspondingly comes down. And, therefore, an investor should be concerned enough to know whether he has taken the right decision to invest in a debt fund or not, and if yes, then should also know how long he should stay invested to make the best out of the fund.  

What are debt funds?

Simply put, the non-equity funds qualify as debt funds for the purpose of taxation, which will include all types of debt funds, international funds, monthly income plans (MIPs), and Gold ETFs.

An investor would serve his interests better by knowing the full implications of taxes on debt mutual fund before taking the decision to put the hard earned money in a fund.

Besides, the dividend distribution tax paid by the fund house, an investor would incur short-term capital gains if the holding period is less than three years. As per the taxation rules, short-term capital gains would be added to the income and taxed as per the individual's income tax slab. And, thus, the consensus among the fund managers is that debt funds would not be superior to other options of fixed deposits in banks if the holding period is less than three years. The tax slab as is known is nil tax for income up to two lakh, 10 per cent for income between Rs 200,001 to Rs 5,00,00, 20 per cent for income between Rs 5,00,001 to Rs 10,00,000, and 30 per cent for income above Rs 10 lakh.  

In case, the holding period is of three years, the investor will incur long-term capital gains, which come with flat 20 per cent but with indexation. Indexation is the process which adjusts inflation from the time an investor gets into the fund till the exit. This process allows an investor to inflate the purchase price of the mutual fund units to take into account the impact of inflation. This gives an investor the benefit of lowering tax liability.

The government in 2013 had introduced rebates as well, which is of Rs 2,000 for total income upto Rs 5,00,000. In addition, those who are above 60 years of age but below 80 years, the basic exemption is Rs 2,50,000, which in the case of those who are above 80 years of age is Rs 5,00,000.

Besides, three per cent education cess is applicable across all tax slabs. Also, a 10 per cent surcharge is applicable on income exceeding Rs 1 crore. 


Growth or Dividend?

In fact, an aware investor needs to make the prudent choice to understand the tax implications before choosing a fund, and he should seek to know whether he should go for a fund with the option of dividend or growth. It may be borne in the mind that a realistic assessment can only be made by factoring in the returns of the fund post taxes, and should stay away from the lure of pre-tax return picture often shown to a prospective buyer of a mutual fund product.

Needless to say no dividend is given in a fund plan which is growth oriented. The
fund managers are of the opinion that growth funds are best suited for those who are keen for long term investment. It naturally gives the benefit of compounded growth to an investor. Also, all income under a growth fund would attract only long term capital gains if held for three years or more. This, off course, is in contrast to dividend option, which is suited to serve the needs of the regular income of the investors. But it must not be taken for granted that the dividends would necessarily be paid out, as it all depends on the fund. 

In addition fund houses also offer the option of dividend re-investment in which case dividends would not be paid out be reinvested in the scheme and the investor gets additional units of the scheme. But it has to clear that the new units would be treated as new investment and would invite the normal lock-in restriction as laid out by the fund houses and also for the taxation purposes. The fund houses may also impose entry and exit loads if the new units are sold within the lock-in restriction. 

And, thus, an investor has a choice to choose between a growth fund or a dividend re-investment fund if he is not comfortable with DDT eating away the gains from the dividend pay out options.

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