After reading about the dividends distribution tax that companies pay on dividends you get as a shareholder, you must be wondering if the same rules apply to even mutual funds. Mutual funds are a different beast altogether, but yes they too have Dividend Distribution Tax (DDT). There are some minor differences though.
Mutual funds can be broadly divided into Equity Funds and Non-Equity Funds (these include Debt, liquid, Gold funds or fund of funds, etc.). When you invest in any mutual fund, you have to option to choose either Growth Option or Dividend Option.
In the Growth Option, the fund doesn’t announce any dividends and instead it keeps all the money it earns (via capital appreciation or dividends from the companies) within the fund itself. Whereas choosing the Dividend Option, means the fund can announce dividends every year – remember “can” and not “must“. Whenever they announce dividends, they announces Rs. X per unit. You just have to multiply that amount with the number of units you hold. That would be the cheque or bank credit you would receive.
So lets now see how dividends are taxed depending upon the type of fund. Do remember that dividends are not taxed in the hands of the investor. It’s just the fund that needs to pay the DDT to the government. By the time it reaches your bank account, you can use it however you want.
Equity Mutual Funds
When an equity mutual fund (having minimum 65% exposure in equity) declares dividends, it needs to pay 0% taxes. Yes, there is no Dividend Distribution Tax at all on equity mutual funds. So any money you get out of equity funds, whether as dividends or as capital gains (after a year) is tax-free. This is a great benefit the government has given to improve more retail participation in equity markets.
Non-Equity Mutual Funds
When you invest in any fund which has less than 65% holding in domestic equity – be it pure debt funds, liquid funds, fund of funds, gold funds, or even funds which invest in international equity, there is a dividend distribution tax involved. If you are an individual investing in such funds, any dividend is taxes at 25% (previously it was 12.5% for debt funds, but recently increased). Add surcharge and education cess to it – you get a total tax rate of 28.325%.
The fund needs to pay this 28.325% as dividend distribution tax whenever it announces dividends. This is all paid for you by the fund house, so you don’t have to worry about it. But since this is a sizeable percentage from your investments, you need to keep this in mind when you choose the type of option when investing.
When the DDT was 12.5%, investors falling in the two highest income tax brackets (20 or 30%) chose to invest the dividend option – especially the dividend reinvestment option. But now that the DDT itself is 28.325%, it is not advisable to invest in dividend option. Now, it is more profitable to invest in the growth option, so that all the money is kept within the fund to grow its value.
Systematic Withdrawal Plan to the rescue
Incase you need a regular payout like a dividend, you can choose the Systematic Withdrawal Plan (SWP). Just like Systematic Investment Plan, where you invest a fixed amount every month or quarter, SWP allows you to withdraw a fixed amount every month or quarter or year. You get back this money just like a dividend, but without paying such high taxes. This is very helpful for people who are retired and want some regular income from their investments.
To sum it up, Equity Mutual Funds do not pay any Dividend Distribution Tax at all. All your money belongs to you. Non-Equity Funds needs to pay 28.325% as DDT. Remember that when you choose the investment option.