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Rediff.com  » Business » Why small investors should shift from dividend to growth option

Why small investors should shift from dividend to growth option

August 03, 2018 09:02 IST

Sooner the investors shift, the better it is as a majority of equity funds have single-digit returns since January 31, says Tinesh Bhasin.
Illustration: Uttam Ghosh/Rediff.com

Priyesh Patel approached his mutual fund distributor to change the dividend option in a balanced fund to the growth option.

Patel, who has been investing in the fund for about four years, was advised to stay put.

The distributor's reason: Changing from dividend to growth option will amount to redemption of old units, which will attract tax.

To shift to the growth option, the investments will have to be redone.

In any case, the distributor explained, the tax on redemption as well as on dividend is the same -- 10 per cent.

While the distributor is correct on the taxation, the dividend option will be less tax-efficient in the long run.

The distributor ignored the fact that there is no long-term capital gains tax (LTCG) in case the total gains made on equity investments is below Rs 100,000 in a financial year.

"This relief provided to small investors helps them control and plan their taxes. That's why it makes sense for small investors to shift from dividend to growth option immediately," says Arvind Rao, founder, Arvind Rao and Associates.

 

Assume that Patel had accumulated Rs 500,000 over the past four years in the balanced fund until January 31, 2018.

For computation of LTCG, the investor has to take the fund value as on January 31, 2018, and calculate the gains made after that.

Assume that his fund grew 5 per cent since then. If he redeems now, the gains he made since January 31, 2018, will be Rs 25,000.

If Patel doesn't have any other equity gains, the entire Rs 25,000 will be tax-free as it is below the exemption limit of Rs 100,000.

But if the fund declares Rs 25,000 as dividend, there will be mandatory 10 per cent dividend distribution tax (DDT) on it.

"In the future, an investor can do a systematic withdrawal plan over a few years keeping the overall equity gains below Rs 100,000, and he will not need to pay any LTCG," says Rao.

Investment advisors also point out that sooner the investors shift, the better it is as a majority of equity funds have single-digit returns since January 31.

Systematic withdrawal is more tax efficient not only for equity investments but also in the case of debt funds.

The latter attracts a 28.33 per cent (including cess and surcharge) DDT.

While in equity funds, LTCG applies after a holding period of one year, in debt funds, withdrawal before three years is taxed as short-term capital gains (STCG).

The gains are added to the income of the investor and taxed based on his income tax slab.

If an investor's tax slab is 20 per cent or lower, s/he will still end up paying much higher tax if s/he opts for the dividend option in a debt fund.

Dividend option in debt funds only works for those in the highest tax bracket, who want some cash flow from the first year of the investment.

"If an investor is in the highest tax bracket (33.99 per cent including cess and surcharge), s/he still ends up saving 5.7 percentage points on returns," says Malhar Majumder, partner and consultant at Positive Vibes Consulting and Advisory.

To make withdrawal more tax-efficient, Majumder says the best option is to start the systematic withdrawal plan after three years of investment.

Tinesh Bhasin
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