Intermediate

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

Dividends are the mechanism through which profits made by a mutual fund on its investments are redistributed to investors. Dividends will generally come out of the excess return that the fund manager has been able to create for the investors, or from dividends payable on investments they hold.

Mutual funds and dividends

Mutual funds offer investors 3 options:

1. Dividend payout option: Under this option, you receive dividends declared by the fund.

2. Dividend reinvestment option: Under this option, the dividend due to you is reinvested on your behalf at the prevailing NAV and the units are added to your existing investment.

3. Growth option: Under this option, no dividends are declared; instead, the profits are retained within the scheme resulting in a higher NAV than the dividend options.

There are pros and cons to each of the above options. Let’s take a closer look at them:

Dividend Payout Option:

- When to consider? When you need cash flows from your investment.
- Benefit: You receive tax-free income (dividend) from your investments.
- Drawback: The scope of capital appreciation is reduced to the extent of the dividend payout.

Dividend Reinvestment Option:

- When to consider? When capital appreciation is the main motive.
- Benefit: You can earn higher returns as the dividends are reinvested in the scheme. Dividends declared (though not paid) are tax-free in your hands.
- Drawback: Investors do not get any payout during the term of the investment. Returns can be realized only through redemption (sale of the fund units).

Growth Option

- When to consider? When capital appreciation is the main motive.
- Benefit: Investors can earn highest possible returns as all profits are ploughed back into the scheme.
- Drawback: Investors do not get any payout during the term of the investment. Returns can be realized only through redemption (sale of the fund units).

You must choose the option that suits your financial goal.