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Mutual Funds: Shift to growth option for tax-efficient returns

Saikat Neogi
mutual fund, mutual fund investment, MF, mid cap funds, small cap fund, large cap funds, How to select best mid cap funds, Expense Ratio

Mutual fund investors falling in higher tax brackets should ideally shift from dividend to growth option as the Budget has proposed that dividend received by shareholders will be taxed as per the investor’s tax slab. Moreover, as per the Budget proposal, any dividend income from mutual funds above Rs 5,000 will attract TDS at the rate of 10% under the newly introduced section 194K. In the growth option of equity-oriented mutual funds, the surplus generated remains within the scheme to generate capital appreciation over a long period of time. In dividend option, the fund house distributes the surplus generated from the scheme to investors. The declared dividend can also be re-invested by buying additional units of the scheme and adding to the existing holdings.

Joydeep Sen, founder, says mutual fund investors should definitely look at shifting to the growth option from dividend option as dividends are taxable at the marginal slab rate of the investor from April 1, 2020. "In the growth option, there are defined taxation rates as against slab rates. In equity funds, for a holding period of more than one year in the growth option, long term capital gains tax rate is 10% plus surcharge and cess, against the marginal slab rate of 30% plus surcharge and cess for most investors. In debt funds growth option, for a holding period of more than three years, long term capital gains tax rate is 20% after the benefit of indexation," he says.

Growth vs dividend options

Analysts say investors should choose either the dividend or the growth options after carefully analysing the cash flow needs. If one needs regular income, especially after retirement, then one should opt for dividend option. However, if you want your money to grow for the long-term and get the compounding benefit, then growth is the best option. Brijesh Damodaran, managing partner, BellWether Advisors LLP, says that if the investor’s tax bracket is below Rs 15 lakh annually, then one can look at the dividend option. "If the tax bracket is at 30% or even 20%, then growth option needs to be considered. However, if an investor is looking at dividends as cash flow, then one can revisit the existing arrangement and look at moving part of the holdings to growth," he says.

Damodaran explains that investments are done for wealth creation (growth) and /or cash flow (dividends). "If a mutual fund investor is in a lower tax bracket, looking at higher quantum of dividend being received, one can move/ switch to the growth option. At the same time, since the introduction of dividend distribution tax (DDT), the quantum of dividend being distributed had come down," he says.

At present, dividends received on investment in equity funds are tax-free in the hand of the investor. Asset management companies pay the dividend and then distribute the net amount as dividends. The Finance Bill 2020 proposes to abolish income distribution tax and instead proposes to tax income from mutual fund units in the hands of the unit holders.

SWP is better

If an investor is looking for regular cash flow, a systematic withdrawal plan (SWP) to redeem a predefined amount of investment can be a better option. In fact, mutual funds cater to two types of investor needs - one, where an investor withdraws a fixed amount every month and the other, where an investor withdraws only the capital appreciation and not the initial capital.

Ideally, SWP helps an investor, especially a pensioner, to work out the cash flow as per his requirement. The problem arises when the equity fund suffers sharp decline in net asset value as the investor would then be withdrawing more capital and getting less capital appreciation. Moreover, SWP holders are also able to secure higher unit prices than those who withdraw the whole amount at once.

As the income from SWPs from the growth option of the fund is redemption and not dividend, there is no dividend distribution tax. However, capital gains tax will be applicable on appreciation.