Sudha wrote a comment a few days ago about the effect of Direct Tax Code (DTC) on dividends from equity mutual funds, and I’ve been meaning to do a post on it since then.
Currently, dividends from equity mutual funds are completely exempt, which means that there is no tax on them at all. Equity mutual funds are unique in this because equity shares are taxed using the dividend distribution tax, and so do debt mutual funds. This tax is collected from the company or the fund issuer, and not the investor, but reduces the money you get nevertheless.
With the DTC implementation, the dividend of an equity mutual fund will be taxed at 5%, and this will have to be paid by the mutual fund holder.
(Source: Direct Tax Code, Tax on Distributed Income, Chapter VIII)
The capital gains on these mutual funds will be taxed at redemption as well, so with the new DTC rule coming in, it’s better to buy the growth option of these equity mutual funds than it is to buy the dividend option.
Even without this option I’ve been in favor of putting money in growth option rather than dividend option because that allows your money to compound for longer, and helps it grow.
I constantly hear people talking about getting money from dividends to pay off some other expense like a insurance payment, or an ELSS payment, but that doesn’t make much sense to me.
It’s true that you “feel” that a payment was made without money going out of your pocket, but it’s your money regardless! Now, you have that much less invested in the market and reduced from your net worth.
On a semi related note, I know that a lot of people who have credit card debt are advised to start using cash instead of plastic because if you have to pay Rs. 1,000 in cash money it pains a lot more than if you just had to swipe a card. I can understand and appreciate this psychology, and I think something similar is at play when you can use a dividend to pay off an expense, but I can’t appreciate that, and certainly wouldn’t advise a friend to choose a dividend option for just this reason.
In any case, if nothing changes between now and when DTC kicks in – you should be aware of this 5% tax on dividends of equity mutual funds, and make a decision keeping it in mind.