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Slash mutual fund Dividend tax with Growth option

You can take your returns from mutual funds either in the form of dividends (Dividend option) or as capital gains (Growth option).

Contrary to popular perception, dividends too are taxable.

Further, in the 2014-15 budget, the calculation of dividend distribution tax was tweaked. So now you have to pay more tax on your dividend.


The solution to all this trauma of tax on dividends is to select Growth option for your mutual fund investments.

Important : This discussion applies to non-equity oriented funds such as debt funds, gold ETF, gold funds, FMPs, international funds, MIPs, etc.


Based on your period of holding, there are two scenarios to consider. For holding period up to 3 years, the returns would be considered as Short Term Capital Gains for income tax purposes. Beyond 3 years, your gains get classified as Long Term Capital Gains.

Holding period up to 3 years or Short Term Capital Gains
Suppose you invest Rs.1 lakh in a debt mutual fund @ Rs.20 NAV. You receive 5000 units. After 2 years, the NAV is Rs.24. It, then, declares a dividend of Rs.4 per unit. Now,
- the NAV after dividend payout will drop to Rs.20 (Rs.24 - Rs.4) for those invested in the Dividend Option
- whereas the NAV under Growth option will remain at Rs.24

a) Tax Liability under Dividend Option
- Total dividend received = Rs.20,000 (5000 units * Rs.4/unit).
- This is fully taxable at Dividend Distribution Tax Rate of 28.33%.
- So tax liability = Rs.5,666
- Value of investment = Rs.1 lakh (5000 units * Rs.20/unit).

b) Tax Liability under Growth Option
- Amount redeemed = Rs.20,000 (for like to like comparison with dividend received)
- No. of units redeemed = 833 (Rs.20,000 / 24)
- Original cost of units redeemed = Rs.16,667 (833 units * Rs.20)
- Short term capital gains = Rs.3,333 (Rs.20,000 - Rs.16,667)
- So tax liability = Rs.343 / Rs.687 / Rs.1030 (for 10%, 20% and 30% tax bracket respectively)
- Units remaining = 4167 (5000-833)
- Value of investment = again Rs.1 lakh (4167 units * Rs.24/unit).

Holding period more than 3 years or Long Term Capital Gains
a) Tax Liability under Dividend Option
Same as above i.e. Rs.5,666.

b) Tax Liability under Growth Option
Now you are eligible for indexation benefit. Suppose inflation is 6% p.a.
- Indexed cost after 3 years = Rs.19,850 (Rs.16,667 increases by 6% every year for 3 years)
- Long term capital gains = Rs.150 (Rs.20,000 - Rs.19,850)
- So tax liability = Rs.31 (@20% for all investors)


So next time you invest in mutual funds, keep the above tax working besides you and make the right choice.


Note : If you depend on returns from mutual funds as a source of regular income, opt for Systematic Withdrawal Plan instead of Dividend option.

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