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Dividend in Non Equity Funds – A Wealth Killer


Dividend Payout is one of the most popular option and USP for Mutual Funds. It may be good for equity mutual funds but for non-equity mutual funds, its a wealth killer. Infact Dividend option is “Silent” Wealth Killer as it kills your wealth without your knowledge. As i explained in my post Capital Gain Tax – Short Term Capital Gain that a mutual fund is classified as Equity Mutual Fund only if 65% of its AUM is invested in equity market. Any fund which does not fulfill this condition is non-equity mutual fund. Non-Equity Mutual Funds broadly include Debt Funds, Monthly Income Plan, Balanced Funds with less than 65% equity exposure etc. In this post, we will discuss how Dividend option of such Non-Equity Funds kills your wealth.

Recently one of my client Mr. Shankar invested in debt mutual funds. Being a retired senior citizen, his critical concern was regular source of income and risk free investment. Based on suggestion from his investment advisor, he opted for Dividend option in Debt Mutual Funds. In this case, investment advisor missed most critical point i.e. Dividend Distribution Tax or DDT. Dividend Distribution Tax is levied on Dividends paid/declared by Mutual Fund house on the schemes classified as Non-Equity Mutual Funds. Dividend Distribution Tax is like a TDS i.e. deducted at source @ 28.33%. DDT is deducted from Gross dividend before distribution. DDT is adjusted against NAV of Mutual Fund scheme i.e. NAV will reduce to the extent of DDT deducted. Investor will never come to know about these financial adjustments. In short, dividend is distributed only after DDT deduction therefore i call its as wealth killer. As an investor you are paying Dividend Distribution Tax of 28.33% which in all likelihood, you are not aware of. DDT is applicable even if your income is non-taxable and there is no provision to claim refund or adjust the same.

Be careful with Dividend Option

(a) Check the status of Mutual Fund Scheme: From an investor perspective, it is very critical to know the status of mutual fund scheme if you are opting for dividend option. The most dicey ones are Balanced Mutual Fund. Under these schemes equity exposure varies depending on market conditions. If markets are falling then fund manager may increase exposure to debt and vice versa. There is a possibility that one scheme is classified as Equity Scheme this FY and may be its status will change to “Non-Equity” next FY. If you are keen to opt for Dividend option then it is advisable to avoid such schemes which are on borderline.

(b) Cash Holding: In case when markets are heating up, inflow to schemes performing well increase exponentially. Fund Manager take time to invest if there is sudden surge in AUM. It increase the CASH Holdings of scheme therefore reducing the exposure to equity in terms of % of AUM. There are some schemes with 20% Cash holding as on date therefore they might be practically equity schemes. With sudden increase in cash holding, equity exposure may reduce below 65%. As an investor you cannot keep tab on this factor as it is variable but at the time of investment, you may check cash holding %.

(c) Growth option in Non-Equity Mutual Funds: Funds which are clearly demarcated as Non-Equity Mutual Funds like Debt funds, it is advisable to avoid Dividend option. You should always opt for Growth option. Growth option will help to avoid Dividend Distribution tax which is un-necessary penalty on investor.

(d) Systematic Withdrawal Plan (SWP): As we know that Non-Equity mutual funds are more safe and best suited for risk averse investor. Irony is that Dividend Distribution Tax on Non-Equity Mutual fund, restricts investor to invest in these schemes to generate regular source of income through dividend option. Another most popular option, Fixed Deposit is most tax inefficient. In such a scenario, it is advisable to opt for Systematic withdrawal plan in combination with Growth option of Debt Fund. Under Systematic Withdrawal Plan, investor can withdraw fixed amount or redeem fixed units  every month to generate regular source of income. If investor is not comfortable with SWP or monthly requirement is variable then he/she can redeem the lump sum units as per requirement.

(e) Growth option is tax efficient: There is a common misconception that Dividend is paid by the mutual fund house. Whereas fact of the matter is that Dividend is your own money.  Its like your Left hand is paying to your Right hand. The NAV of the mutual fund scheme drop to the extent of dividend payout. For example if mutual fund scheme declare dividend of Rs 2 per unit than NAV will drop by Rs 2. From taxation purpose, it is not beneficial for investor. Reason being in Dividend option, entire sum is taxed irrespective of gains or profit from mutual fund scheme. Whereas in Growth option only the capital gain from MF scheme is taxed. In growth option, if NAV at the time of purchase is Rs 50 and at the time of sale NAV is Rs 80 than capital gain is Rs 30 per unit. Tax is payable only on gains i.e. Rs 30/unit. If capital gain is STCG, it will be taxed as per your income tax slab and in case of LTCG, you can claim indexation benefit.

(f) Capital Gain Tax: Before investment, it is advisable to consider the taxability of  maturity amount. Long term Capital Gain Tax on Equity funds is NIL and for Non-Equity funds it is 20% with indexation. Min holding period of Equity funds is 1 years and for non-equity funds its 3 years for LTCG. This is inherit disadvantage of non-equity funds.

To summarize, Growth option is always advisable for wealth creation. Dividend option is best suited for investors who need regular source of income and that too from equity schemes. For Non-Equity mutual funds, It is always advisable to opt for Growth option irrespective of investment objective. In case regular source of income is prime concern then you may opt for Systematic Withdrawal Plan (SWP).

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Copyright © Nitin Bhatia. All Rights Reserved.

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Vinod Bhola
Vinod Bhola
8 years ago

Dear Mr. Nitin, How do I contact you so as to make my portfolio tax efficient as well as get regular returns. I am 70 + years old. Thanks.

Nitin Bhatia
Nitin Bhatia
8 years ago
Reply to  Vinod Bhola

You can call me at +91 9480021000 or +91 9820177393

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