“Mutual funds are subject to tax changes, read budget documents carefully before investing.”
This is the new disclaimer which SEBI should make MFs display in their ads. Going by last 10 year’s budget, Mutual Funds have bore the brunt of smart lobbying by Banks to change taxes and remove the arbitrage between fixed deposits and debt funds.
This Union budget 2020 was yet another year where we saw some major change in MF taxation. Such frequent tax changes can sometime disturb our goal planning and one needs to be careful about the impact it can have on the portfolio.
One such important change was the way dividends from mutual funds will be taxed. Dividend distribution tax in Mutual Fund is set to go, but wait before your cheer. In turn, dividends will now be taxed as per your income tax slab. So if you receive Rs. 10,000 dividend and you fall in 20% tax bracket, then you pay 20% tax on Rs. 10,000 dividend that you recieve.
Secondly, it is proposed to deduct TDS @ 10% on such dividends if the amount of dividend exceeds Rs. 5,000.
While this proposed tax will reduce tax liability in debt mutual fund dividends for individual who are in lower tax brackets, it will increase tax liability in equity fund dividends for investors who fall in 30% tax bracket or pay surcharge.
As of now Debt MF dividends are taxed @ 25% + 12% surcharge + 4% cess for individuals and 30% + 12% surcharge + 4% cess for corporates. Equity MF dividends are taxed @10% + Surcharge + Cess. This will change to one tax structure. Dividends will now be added to your income and will be taxed as per your income tax slab.
What should you do?
If you have invested in equity fund dividend option and you fall in more than 10% tax bracket then it is suggested to switch to growth. Equity long term capital gains are taxed at 10% and short term capital gains are taxed at 15%.
If you are invested in debt fund dividend option and intend to hold this for long term (more than 3 yrs) then it is suggested to switch to growth option. Debt fund long term capital gains are taxed at 20% after indexation, surely lower than marginal tax rate you will pay in dividend option. Even if you are investing for short term (less than 3 yrs) and you fall in any tax bracket it is suggested to invest in growth option as it will reduce the hassles of computing gains of frequently paid dividends while filing your returns. In short term i.e. less than 3 years, both growth and dividends will be taxed as per your income tax slab.
Investors who fall in lower tax slabs can choose to continue dividend option, but as their income grows they may have to eventually switch to growth option. Hence, it makes sense to dump the dividend option at first go. However, dividend option is good for retirees who don’t have too much of taxable income and generally don’t see their income growing. They are also good for non-working spouse as they may get tax exempted gains every year. However, with the changes in tax I strongly feel that AMCs will reduce dividends from next year. Why will they want an outflow of AUM. Earlier aggressive dividend strategy would get them new flows, but not anymore. We will have to wait and watch.
At the core, dividend option in MFs anyways have too many flaws. They are not consistent, they are nothing but return of your income and in some cases also capital (when your fund is not growing, but you still get dividends) In such cases you will pay taxes on your own capital.
Systematic Withdrawals (SWP) are much better. They offer predictability and now also less taxing. In SWP you pay returns only of gains and not on complete withdrawals and hence, they are more tax efficient. Read a detailed blog on why SWP is better than dividend which I had written a year back SWP is better.
So next time you invest in mutual funds read the taxation carefully. The goal post keeps changing, don’t shoot a self goal.