DDT removed: What different mutual fund investors should do to maximise gains

Finance Ministers in India are known to shift goal posts when presenting budgets and Nirmala Sitharaman was no exception. The removal of dividend distribution tax (DDT) and making dividends taxable in the hands of investors was one such move. Since investors would have opted for the dividend route for various reasons, let us analyse the impact of the move on different sets of investors.

First are the savvy investors, who chose the dividend option for tax arbitrage. Their tax slab would be higher than the applicable DDT rates and they were using the dividend option to save the difference. A DDT of 11.65% is lower than the short-term capital gains (STCG) tax from equity mutual fund of 15.6%. However, the DDT is slightly higher than the long-term capital gain (LTCG) tax rate of 10.4%. More importantly, tax is applicable only on LTCG of more than Rs 1 lakh from equities in a financial year. In this scenario, the dividend option in equity schemes made perfect sense for investors with a holding period of less than one year—the cut-off that differentiates short-term and long-term capital gains for equity mutual funds. Since most of these investors are from the higher tax brackets, it no longer makes sense to remain in the dividend option. They would be better off with growth option.

What about those who chose the dividend option in debt schemes? Since the DDT here is a high 29.12%, only people from the 30% plus tax brackets used this for tax arbitrage. The holding period for LTCG is more—3 years in debt funds compared to 1 year for equity funds—and LTCG from debt funds are also taxed favourably. LTCG in debt funds are taxed at 20% after indexation. If one assumes an annualised return of 7% and 5% inflation, the effective tax will be only 5.94%. This means growth is the best option for anyone with a holding period of more than 3 years.

With dividend made taxable, the growth option is more beneficial

Since dividend is taxable, there is another advantage of being in growth plans now. “Unlike dividends, which are declared by the mutual fund company , investors can decide when to book profit in growth options,” says Vishal Dhawan, CEO, Plan Ahead Wealth Advisors.

Next we come to the financially non-savvy investors from the lower income tax brackets, who are ignorant about the impact of DDT. They have invested in dividend options after being lured by the ‘tax free dividend’ propaganda unleashed by a few fund houses and their distributors. “Most investors believe that mutual fund dividend is tax free because they don’t understand the concept of DDT. Hope the removal of DDT will increase their awareness,” says Dhawan. Since DDT was being paid by the mutual funds on behalf of investors, it was not tax-free in the truest sense. Investors were actually paying the tax, which was much more than what they should have paid otherwise. Their effective tax liability will come down now. In other words, removal of DDT has been a good thing for them.

What should investors do now? They can continue to be in dividend options if they are not in any tax bracket or in very low tax slabs. However, they should note that the government has introduced tax deduction at source (TDS) on dividends and the limit set for that— Rs 5,000 per annum—is very low. “The Rs 5,000 per annum limit is very low. The TDS limit on dividends used to be Rs 10,000 earlier, before the introduction of DDT. To be in line with market reality, this should be at least Rs 1 lakh,” says G. Pradeep Kumar, CEO, Union Mutual Fund. Though people outside tax brackets can file income tax return and get refund, it will be a cumbersome process. “More investors are expected to shift to growth options now because the TDS and its low threshold will make dividend option less attractive,” says A. Balasubrahmanian, CEO, Birla Sun Life Mutual Fund.

The third set of investors were using dividend options for cash flow management. “Using dividend for cash flow needs is not good idea, because dividends are not guaranteed and it may keep on varying,” says Dhawan. What should such investors do now? “Instead of dividend options, investors can use systematic withdrawal plans (SWPs) for predictable cash flows,” says Balasubrahmanian. Experts feel this trend will accelerate now. “We are expecting investors to shift from dividend to growth plans now,” says Kumar.

Other positives
The withdrawal of DDT has other positives as well. “Since the DDT on company dividends has gone, this will increase the dividend yields of mutual fund portfolios,” says Balasubrahmanian. Increased dividend yield means better appreciation in the NAV. The second positive is the forced shift to growth options. “Dividend from mutual funds is not a dividend in the true sense; it is just your money coming back. Since the chance of spending is less, power of compounding works best with growth options,” says Vikaas Sachdeva, CEO, Emkay Investment Managers.