Your investment in mutual funds can give you profits in two forms — Dividend or Capital Gains.
Further, the Capital Gains can be in two forms — Short Term Capital Gains or Long Term Capital Gains.
The subject matter of this blog post is to minimize the tax liability on your profits from mutual funds. So equity-oriented mutual funds are excluded.
Why?
Because, on these schemes you anyway don't have to pay any tax, whether you (a) receive dividends or (b) make capital gains on units held for more than a year (note: equity as an investment is not advisable for less than a year of time-horizon).
Hence, this discussion covers only the non-equity oriented mutual funds. This includes all kinds of debt funds (such as income funds, short-term / ultra short-term funds, liquid funds, gilt funds), gold funds, MIP schemes and international funds.
As you may be aware,
- If you choose Dividend Option you will receive "dividends" from time to time (plus, there may be some increase in NAV, giving you capital gains too).
- If you choose Growth Option, NAV of your units will keep increasing, giving you "capital gains" when you sell your units.
[Important Note: You will make the same "pre-tax" gains, whether you invest in the Growth or Dividend option. The choice is merely an accounting entry. It has no relation whatsoever, to the basic fund management and hence the basic returns that you can earn.]
These "capital gains" are classified as
- Long-Term when the holding period is more than 3 years, and
- Short-Term when you sell your units, in less than 3 years from the date of purchase.
Keeping these points in mind, let's plunge into the subject matter of this article. Also read about the shocking mistakes mutual fund investors often commit.
Here's a simple example of a typical investment in a debt mutual fund:
Amount invested = Rs.1 lakh
Net Asset Value (NAV) on the date of purchase
- Growth Option : Rs.20
- Dividend Option : Rs.20
(For better understanding, I have assumed the same starting NAV under the Growth and Dividend options. Normally, these are different. But that doesn't matter at all because, as explained in the past, NAVs are "Not Applicable Value").
No. of units alloted = 1,00,000 / 20 = 5000
For like-to-like comparison, I have assumed that the investment is redeemed immediately after the dividend is declared.
Dividend declared (under Dividend Option) = Rs.4 / unit
Net Asset Value (NAV) on the date of sale
- Growth Option = Rs.20 + Rs.20*20% = Rs.24
- Dividend Option = Rs.20 + Rs.20*20% - Rs.4 = Rs.20 (entire profit declared as dividend)
a) Tax Payable under Dividend Option
Law: Mutual fund companies have to deduct Dividend Distribution Tax (DDT) on the dividend payable.
Amount of Dividend Payable = Rs.4/unit * 5000 units = Rs.20,000
Rate of Tax = 28.84% (including surcharge and cess)
Tax deducted at source in the form of DDT = Rs.5,768
Sale value of investment = 5000 units * Rs.20/unit = Rs.1 lakh
Total amount received in hand = 1,00,000 + 20,000 - 5,768 = Rs.1,14,232.
b) Tax Payable under Growth Option
Law: You have to pay tax on the Long Term Capital Gains.
Rate of Tax = 20% with indexation benefit (+ surcharge and cess)
Cost of investment = Rs.1,00,000
Indexed Cost of Investment = Rs.1,00,000/100*119 = Rs.1,19,000
(Assuming cost inflation index of 100 in the year of purchase and 119 in the year of sale)
Sale value of investment = 5000 units * Rs.24/unit = Rs.1,20,000
Long Term Capital Gains = 1,20,000 - 1,19,000 = Rs.1,000
Tax payable = 23.69% * 1,000 = Rs.237
Total amount received in hand = 1,20,000 - 237 = Rs.1,19,763.
Thus, under Growth Option you make a huge (huge) savings on your tax liability.
Dividend declared (under Dividend Option) = Rs.4 / unit
Net Asset Value (NAV) on the date of sale
- Growth Option = Rs.20 + Rs.20*20% = Rs.24
- Dividend Option = Rs.20 + Rs.20*20% - Rs.4 = Rs.20 (entire profit declared as dividend)
a) Tax Payable under Dividend Option
Law: Mutual fund companies have to deduct Dividend Distribution Tax (DDT) on the dividend payable.
Amount of Dividend Payable = Rs.4/unit * 5000 units = Rs.20,000
Rate of Tax = 28.84% (including surcharge and cess)
Tax deducted at source in the form of DDT = Rs.5,768
Sale value of investment = 5000 units * Rs.20/unit = Rs.1 lakh
Total amount received in hand = 1,00,000 + 20,000 - 5,768 = Rs.1,14,232.
b) Tax Payable under Growth Option
Law: You have to pay tax on the Short Term Capital Gains.
Rate of Tax = As per your income tax bracket (+ surcharge and cess)
Cost of investment = Rs.1,00,000
Sale value of investment = 5000 units * Rs.24/unit = Rs.1,20,000
Short Term Capital Gains = 1,20,000 - 1,00,000 = Rs.20,000
Tax payable
- 10% tax bracket = 11.845% * 20,000 = Rs.2369
- 20% tax bracket = 23.69% * 20,000 = Rs.4738
- 30% tax bracket = 35.535% * 20,000 = Rs.7107
Total amount received in hand
- 10% tax bracket = 1,20,000 - 2369 = Rs.1,17,631
- 20% tax bracket = 1,20,000 - 4738 = Rs.1,15,262
- 30% tax bracket = 1,20,000 - 7107 = Rs.1,12,893
Thus, under Growth Option you make good savings on your tax liability, if you are in the lower tax brackets. But the highest tax bracket person is at a slight disadvantage. At 28.84%, Dividend Option is somewhat better than 35.535% Tax Rate on Growth Option.
However, even those in the highest tax brackets should preferably opt for the Growth Option:
Because, it quite likely that you may not sell the entire investment. So, on the part portion sold before three years, you pay a marginally higher tax. But on the balance amount, which you sell after three years, you make substantial tax savings.
In short, Growth Option is (almost) always desirable.
Question: I need regular monthly income from my debt funds. Do I still go for the Growth Option and skip the Dividend Option?
Answer: Of course. For receiving regular income — with lower tax liability — mutual funds have a simple process. Just as you have automatic monthly investment by way of SIP (i.e. Systematic Investment Planning), you can set up automatic monthly redemption i.e. Systematic Withdrawal Plan (SWP). For more details on this, you can read SIP, STP and SWP : Mutual fund mumbo jumbo.
Further, the Capital Gains can be in two forms — Short Term Capital Gains or Long Term Capital Gains.
The subject matter of this blog post is to minimize the tax liability on your profits from mutual funds. So equity-oriented mutual funds are excluded.
Why?
Because, on these schemes you anyway don't have to pay any tax, whether you (a) receive dividends or (b) make capital gains on units held for more than a year (note: equity as an investment is not advisable for less than a year of time-horizon).
Hence, this discussion covers only the non-equity oriented mutual funds. This includes all kinds of debt funds (such as income funds, short-term / ultra short-term funds, liquid funds, gilt funds), gold funds, MIP schemes and international funds.
As you may be aware,
- If you choose Dividend Option you will receive "dividends" from time to time (plus, there may be some increase in NAV, giving you capital gains too).
- If you choose Growth Option, NAV of your units will keep increasing, giving you "capital gains" when you sell your units.
[Important Note: You will make the same "pre-tax" gains, whether you invest in the Growth or Dividend option. The choice is merely an accounting entry. It has no relation whatsoever, to the basic fund management and hence the basic returns that you can earn.]
These "capital gains" are classified as
- Long-Term when the holding period is more than 3 years, and
- Short-Term when you sell your units, in less than 3 years from the date of purchase.
Keeping these points in mind, let's plunge into the subject matter of this article. Also read about the shocking mistakes mutual fund investors often commit.
 |
| May I help you to cut tax, on the returns from your mutual fund investments? |
Here's a simple example of a typical investment in a debt mutual fund:
Amount invested = Rs.1 lakh
Net Asset Value (NAV) on the date of purchase
- Growth Option : Rs.20
- Dividend Option : Rs.20
(For better understanding, I have assumed the same starting NAV under the Growth and Dividend options. Normally, these are different. But that doesn't matter at all because, as explained in the past, NAVs are "Not Applicable Value").
No. of units alloted = 1,00,000 / 20 = 5000
For like-to-like comparison, I have assumed that the investment is redeemed immediately after the dividend is declared.
Scenario 1: Long Term Investment i.e. holding period EXCEEDING 3 years
Profit made by the fund = 20%Dividend declared (under Dividend Option) = Rs.4 / unit
Net Asset Value (NAV) on the date of sale
- Growth Option = Rs.20 + Rs.20*20% = Rs.24
- Dividend Option = Rs.20 + Rs.20*20% - Rs.4 = Rs.20 (entire profit declared as dividend)
a) Tax Payable under Dividend Option
Law: Mutual fund companies have to deduct Dividend Distribution Tax (DDT) on the dividend payable.
Amount of Dividend Payable = Rs.4/unit * 5000 units = Rs.20,000
Rate of Tax = 28.84% (including surcharge and cess)
Tax deducted at source in the form of DDT = Rs.5,768
Sale value of investment = 5000 units * Rs.20/unit = Rs.1 lakh
Total amount received in hand = 1,00,000 + 20,000 - 5,768 = Rs.1,14,232.
b) Tax Payable under Growth Option
Law: You have to pay tax on the Long Term Capital Gains.
Rate of Tax = 20% with indexation benefit (+ surcharge and cess)
Cost of investment = Rs.1,00,000
Indexed Cost of Investment = Rs.1,00,000/100*119 = Rs.1,19,000
(Assuming cost inflation index of 100 in the year of purchase and 119 in the year of sale)
Sale value of investment = 5000 units * Rs.24/unit = Rs.1,20,000
Long Term Capital Gains = 1,20,000 - 1,19,000 = Rs.1,000
Tax payable = 23.69% * 1,000 = Rs.237
Total amount received in hand = 1,20,000 - 237 = Rs.1,19,763.
Thus, under Growth Option you make a huge (huge) savings on your tax liability.
Scenario 2: Short Term Investment i.e. holding period LESS THAN 3 years
Profit made by the fund = 20%Dividend declared (under Dividend Option) = Rs.4 / unit
Net Asset Value (NAV) on the date of sale
- Growth Option = Rs.20 + Rs.20*20% = Rs.24
- Dividend Option = Rs.20 + Rs.20*20% - Rs.4 = Rs.20 (entire profit declared as dividend)
a) Tax Payable under Dividend Option
Law: Mutual fund companies have to deduct Dividend Distribution Tax (DDT) on the dividend payable.
Amount of Dividend Payable = Rs.4/unit * 5000 units = Rs.20,000
Rate of Tax = 28.84% (including surcharge and cess)
Tax deducted at source in the form of DDT = Rs.5,768
Sale value of investment = 5000 units * Rs.20/unit = Rs.1 lakh
Total amount received in hand = 1,00,000 + 20,000 - 5,768 = Rs.1,14,232.
b) Tax Payable under Growth Option
Law: You have to pay tax on the Short Term Capital Gains.
Rate of Tax = As per your income tax bracket (+ surcharge and cess)
Cost of investment = Rs.1,00,000
Sale value of investment = 5000 units * Rs.24/unit = Rs.1,20,000
Short Term Capital Gains = 1,20,000 - 1,00,000 = Rs.20,000
Tax payable
- 10% tax bracket = 11.845% * 20,000 = Rs.2369
- 20% tax bracket = 23.69% * 20,000 = Rs.4738
- 30% tax bracket = 35.535% * 20,000 = Rs.7107
Total amount received in hand
- 10% tax bracket = 1,20,000 - 2369 = Rs.1,17,631
- 20% tax bracket = 1,20,000 - 4738 = Rs.1,15,262
- 30% tax bracket = 1,20,000 - 7107 = Rs.1,12,893
Thus, under Growth Option you make good savings on your tax liability, if you are in the lower tax brackets. But the highest tax bracket person is at a slight disadvantage. At 28.84%, Dividend Option is somewhat better than 35.535% Tax Rate on Growth Option.
However, even those in the highest tax brackets should preferably opt for the Growth Option:
Because, it quite likely that you may not sell the entire investment. So, on the part portion sold before three years, you pay a marginally higher tax. But on the balance amount, which you sell after three years, you make substantial tax savings.
In short, Growth Option is (almost) always desirable.
Question: I need regular monthly income from my debt funds. Do I still go for the Growth Option and skip the Dividend Option?
Answer: Of course. For receiving regular income — with lower tax liability — mutual funds have a simple process. Just as you have automatic monthly investment by way of SIP (i.e. Systematic Investment Planning), you can set up automatic monthly redemption i.e. Systematic Withdrawal Plan (SWP). For more details on this, you can read SIP, STP and SWP : Mutual fund mumbo jumbo.
