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Dividend Distribution Tax in Mutual Funds

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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.

Summary

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.

How much taxes should you pay on dividends?

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Dividends are a way to get easy profits, without even having to work in a company. But lot of people have the question of how much taxes does one owe to the government. Here is the easy answer:

ZERO TAXES

Yes, you read that right. Shareholders do NOT have to pay any taxes on dividends earned. That is great right? You get all the profits from the company and you also don’t have to give to the government any share.

But the government wouldn’t give up on such an easy money, right? True. That is why the government asks the company to pay something called a Dividend Distribution Tax (DDT). The company needs to pay a flat 15% DDT on all dividends that it wants to distribute to the shareholders, even before it pays out the dividend. On the 15% DDT, they also need to pay 10% surcharge and an education cess of 3% – leading to a total of 16.995% (FY 2013-14).

You as a shareholder do not have to worry about all this, as the DDT is paid for you by the company directly. So any money you get as dividend in your bank account is tax-free. You may think that it is great, right? Company handles all the taxation and you also get nice profit as an investor.

But remember you do lose 16.995% of your money to the government. Since dividend is calculated on after-tax profit of the company, DDT is an extra expense for your company. Remember, Income tax on profits is 30% (+surcharge +cess) and whenever the company declares dividends, an extra 15% (+ surcharge +cess) is paid.

Almost 50% of your money (earned in the business) is given away to the government whenever you get dividends. That is why there are two kinds of companies:

  1. which gives regular dividends to the shareholders
  2. which retain the maximum profits for developing more value out of the system (best example was Apple when Steve Jobs was alive)

Both of these companies are important and shareholders need to have both types of companies to get the best returns out of his investment. Since, India doesn’t tax dividends in the hands of shareholders, many experts will suggest investing in companies which give regular dividends with high dividend yield. At least you get back some money from your investment – almost like a FD in some cases.

Getting back a nice fat cheque (of Rs. 6 crores) tax-free every year is a good enough reason, if you ask me. And as long as the government uses all this money to improve the infrastructure and for the general public, it is a win-win situation for everyone.

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