When it comes to investing in mutual funds, there are a lot of sites which would give you top 10 funds to invest in. But probably there is not much knowledge out there on different payout options available while investing into mutual funds. Take it this way, a wrong payout option chosen while investing into a mutual fund can either defeat your investment objective or land you into avoidable tax bills. This article aims to demistify different options which are available in the MF market and how to make the best out of them to further your investment goal. You may want to refer to our article What is a Mutual Fund which is a precurser to the decisions involved in selecting the right Payout Option.
What is a Payout Options
When investing into a mutual fund, a fund house gives an option to an investor to express his way of receiving the returns in the mutual fund. These are called Payout options. Broadly, there are three options :
Just like shares, mutual funds also declare dividends. These dividends are tax free in the hands of the investors and are sent to the investor via cheque (in case an investor opts for cheque payments) or credited directly into the bank account of the investor (in case an investor opts for the direct bank credit option).
Dividend Distribution Tax
Depending upon the type of mutual fund scheme, a mutual fund house may deduct an upfront DDT-Dividend Distribution Tax (just like TDS) before sending out the payment. For all Equity schemes, the DDT is currently zero. For Bond schemes, it is generally around 15%. For Liquid funds, DDT is around 27%. For details on DDT, you may refer to Tax Implications of Mutual Funds on Residents and NRIs.
When the dividend is declared, the NAV of the respective mutual fund gets reduced by the dividend amount. For example, if the NAV of a mutual fund scheme before declaration of dividend was Rs. 20 and the mutual fund declares Rs. 2 dividend, the NAV after the dividend is paid shall reduce to Rs. 18.
If an investor has opted for Growth option, the mutual fund house shall not provide such an investor with regular dividends which it declares. However, it does not mean that the investor is at loss. The NAV of mutual funds invested with growth option does not decrease by the dividend amount, and hence indirectly the returns of the investor is reflected in the form of higher NAVs.
For example HDFC Equity Fund has a NAV of Rs. 241 (as of 14 May 2012), while the same scheme invested with dividend option on the same date has a NAV of Rs. 37. You may notice that if you had 1000 units in HDFC Equity Fund, the value of your holdings with Dividend Option shall be Rs. 37,000. However, if the investment was made with Growth Option, the value would be Rs. 241,000. The differential amount has been paid back to the investor in the form of Dividend Payout.
From Tax perspective, the investors using growth option get primarily taxed via Capital Gain Tax which is the difference between the cost of investment and the market value of the investment on the date of sale. Depending upon the type of mutual fund, the capital gain can be :
|Non Equity Funds
|10% without Indexation
20% with Indexation
NRIs are taxed slightly differently. For details on taxation on Mutual funds, please refer to our article Tax Implications of Mutual Funds on Residents and NRIs.
This option is a hybrid between Growth Option and Dividend Option. Just like a Dividend Option, the mutual fund house declares a dividend on the scheme. The NAV of the scheme gets reduced by the extent of dividend. However, instead of paying out the dividend in cash, the mutual fund invests the dividend at the ex-dividend NAV in the same scheme.
Lets take a hypothetical example. HDFC Equity Fund has a NAV of Rs. 50, when it gives a dividend of Rs. 10 per unit. Mr. A has 1000 units of the scheme and he is hence entitled for Rs. 10,000 (1000 units X Rs. 10) dividend. However, since he opted to invest with ‘Dividend Reinvestment’ option, the mutual fund house instead of paying him cash, allotted him additional units for Rs. 10,000. So in the example, the ex-dividend price of HDFC Equity Fund falls down to Rs. 40. Mr. A is allotted fresh 250 units (Rs. 10,000 / Rs. 40), taking his total number of unit holdings to 1,250 units. If you would notice, the value of Mr. A’s holding is still Rs. 50,000 (1250 units X Rs. 40 per unit). Hence it didn’t really make a difference if he invested via Growth Option or Dividend Reinvestment from overall value of investment perspective. However, his number of units increased from 1,000 to 1,250.
When to Choose Which Option
We have now reached the most important part of this article which helps to take the decision of the right payout option for your funds. The answer likes in the tax impact of a fund on an individual and the requirement to have regular dividends. Hence, it can not be ‘one size fits all’ response. NRIs get taxed differently than Resident Individual and so does Corporate entities. Even within Resident Individuals, people get taxed differently based upon the amount of their taxable Income. Lets go through each of the options :
When to Choose Growth Option
As per the current tax laws, Long term capital gain tax is tax free for Equities and so is dividend Income. However, this was not always the case. After every 5-6 years, government takes away the ‘Tax-Free’ status of Dividends. Also, depends upon the requirement to incentivise the investment into Equity markets, the goverment may take away the tax rebates on long term capital gain tax on Equities.
Based upon the current tax laws, we can suggest the following :
- Invest into Equity oriented mutual funds with Growth Option as after 1 year the entire amount of gain would be tax free. However, if the tax situation changes, this strategy should be reviewed.
- For Non Equity Funds – Invest with Growth Option only if your total taxable income is less than 10% tax bracket. Long Term Capital Gain Tax on Debt funds get taxed at 10% – 20% rate. However, a resident individual is not required to pay any tax upto the minimum taxable slab (currently Rs. 200,000).
- For NRIs invest only via Growth Option. This would prevent getting additional dividend income being credited in your bank accounts which would attract taxes in your respective foreign country. NRIs may face TDS in case of non-Equity funds at the time of selling the units, however, this amount may be recovered by filing a tax return (only in case of Short Term Capital Gain Tax – Bond Funds).
When to Choose Dividend Option
If you need regular income, you may want to opt for ‘Dividend’ option. Dividend income is currently tax free and hence you can enjoy a tax free income. However, as referred to in the earlier paragraphs, mutual fund houses deduct Dividend Distribution Tax on Debt Funds. Hence from a Tax perspective, you may want to do the following :
- For Non Equity Funds – Invest via Dividend Option in Debt funds if your taxable income is above 20% tax slab. Mutual fund houses deduct around 15% DDT for debt funds (27% for Liquid Funds) and then distribute the income to the unit holder. So if you are in the 30% tax bracket, your returns from the mutual fund shall be distributed to you after deducting 15% tax. The remaining 85% of your returns would then be tax free. Hence for example, if your debt fund has Rs. 1000 return, it shall provide you this return after deducting Rs. 150 as DDT. Remaining Rs. 850 which shall be credited in your bank is tax free.
- For NRIs – do not choose Dividend Option as it would attract additional taxes in your foreign country. Further, DDT deducted on Dividend Option is not recoverable via filing of annual tax return, hence it makes no sense to go via Dividend Option for NRIs.
When to Choose Dividend Reinvestment Option
Dividend Reinvestment Option faces the same tax impact as of Dividend Option and hence follows the same suggestions. With every dividend payout getting invested, it increases the cost of acquisition of the units in the mutual fund. This reinvestment, though tax free for Equity Funds, attracts DDT for Non-Equity Funds which unnecessarily adds as a drag to your overall returns. At the time of final redemption, the market value of the units is very close to the cost of purchase of the units, resulting in no or very less amount of additional taxes to be paid.
Considering that this option does not provide any additional advantage, I tend to stay away with this option as it results in complicating the computation of cost of purchases of the overall units.
The topic of choosing the right option is not very straight forward and may require a bit of digging into each person’s tax status and the requirement to have a regular cash flow. I would strongly recommend to consult your financial advisor who is also proficient to deal in your specific tax scenario to arrive at an optimum Payout option. If you need any specific help, you can ask a question at the bottom of this article.