Mutual Funds Dividend Options – Tax Implications and Switching

 

Mutual Funds Dividend Options – Tax Implications and Switching

Ah! Mutual Funds – aren’t they amazing? Well, there are millions of people around the globe and specifically in India who choose to invest in mutual funds instead of investing or gambling in direct share trading. The reason for this is that mutual funds are considered to be safe. They are safe because they are managed by highly experience fund managers who work continuously (along with team of analysts, statisticians and mathematicians, economists, financial experts and more) to mitigate risks and maximize profit. This safety net of fund managers and their teams is not available in case of direct share trading. This is why mutual funds are considered safer compared to direct share trading despite the fact that mutual funds are nothing other than share trading – only difference – controlled environment of risk mitigation in case of mutual funds.

Okay, now that we have a brief idea of why mutual funds are comparatively safer, it sounds pretty logical as to why people invest in mutual funds. Yet another reason is that mutual funds give dividends. This dividend feature gives what we call, ‘income stream’. This income stream is separate from the income people earn through jobs and businesses. This income stream comes in very handy when it comes to meeting regular expenses. It is no hidden fact that inflation is ever-present. This inflation burns a hole in our pockets and we find it really difficult to deal with rising expenses with limited income. The extra income stream from mutual funds is always a supporting hand that we need today.

So, what we intend to do here is that we want to, in this article, speak about the dividend options and growth options that are associated with mutual funds. We will try to understand the complex mechanism that allows mutual funds to give dividends in the first place. We will try to understand different technical terms like dividends’ tax treatment, fund Face Value, dividend distribution tax, record date etc. We will also try to understand how switching between mutual funds is a possible.

So, we will first like to apologize that this article is going to be a bit lengthy. Stay with us till the end as it is a treasure trove that you don’t want to miss if you really want to make prudent fiscal decisions. All righty then! Let’s start!

Mutual Funds – Growth Options and Dividend Options

Mutual Funds actually come in three variants –

  1. You can go for Growth.
  2. You can go for Dividend.
  • You can go for Dividend Reinvestment.

What are these three options? Let us explore:

Growth Option of Mutual Funds

When you are investing in mutual funds, you are doing so because you expect profits out of your investments. Profits? Well, basically profits refer to interest income that comes to your account against the investment you make. Your original investment money remains intact but you earn some extra money – the interest. This interest is basically you profit.

Now, the Growth Option in mutual funds is an option where the interest you earn or the profit you make simply goes back into investment (that is the scheme that you chose) So, your actual investment amount keeps growing over time and then your interest income was proportionately keeps increasing. This is best if you are actually looking for creating a large pool of money for later years or for some specific purposes such as higher education, marriage etc.

For example (remember that it is only an example and it doesn’t reflect any real-life scenario):

You invest INR 100. You are promised an interest rate of 10% in 1 year. After one year, you will earn, INR 10 as interest earning or profit.

Because you chose for Growth Option, the interest earning is now put back into your chosen scheme. So, your actual investment amount is no longer INR 100 but now it has grown to INR 110. Now, you will earn 10% interest on INR 110 instead of INR 100. So, your profit with new investment amount after a year will be: INR 11. This is 1 rupee more than previous profit you earned.

This is how the Growth Option works.

Dividend Option of Mutual Funds

As opposed to the growth option, you decide not to invest the profit back into your chosen scheme. Instead, you decide to take the profit amount and use it, leaving your original investment intact so that it can keep earning profits over time.

With the same example, as above:

You invest INR 100. You earn a profit of INR 10 in first year because interest rate was 10%. You take the profit and use it for your needs. So, the investment amount remains intact at INR 100. Next year, you again earn INR 10 and take that out as well and then next year another INR 10 and so on. Neither your investment amount increases and nor is there a proportionate increase in your profits.

This is how the Dividend Option works.

Dividend Reinvestment Option in Mutual Funds

You may be naturally inclined to think of this option as Growth Option but, DON’T THINK LIKE THAT. There is a difference. However, before we spell out the difference, you need to know one thing.

Do you remember we said that mutual funds are nothing but share trading in controlled environment of risk mitigation?

So, when you are actually investing in a mutual fund scheme, what you are doing is that you are purchasing shares or bonds.

Suppose you invest INR 100 and you purchase 10 shares worth INR 10 each. This means that each share you buy costs you INR 10 and hence, INR 100 investment will give you only 10 shares.

These shares or bonds that you purchase are basically called units in jargon scenario.

What happens in Dividend Reinvestment option is that when you invest and you make profits, the mutual fund company will declare the profit and then you ask to use that profit money to be reinvested BUT, unlike in growth option, the money will be used for purchasing more units, which will be considered as ‘Fresh Purchase’. Confusing? We will get to this later!

For now,

Difference Between Dividend Payout, Dividend Reinvestment and Growth Options

Points for differentiating Dividend Payout Dividend Reinvestment Growth
Is dividend received? YES NO NO
DDT or Dividend Distribution Tax (we will talk of these later) YES – only for those schemes where equity share is less than 65% YES – only for those schemes where equity share is less than 65% NO
Change in NAV (we will talk of these later) YES – it decreases to the extent to which DDT is applied and dividend is paid YES – it decreases to the extent to which DDT is applied and dividend is paid NO
Change in number of units (we will talk of these later) NO Number of Units Increases NO

What Really is Dividend?

If we go by pure definition found in books, where is what dividend means:

“A corporation that has shareholders may decide to distribute some money (payment). This payment is basically a part of the corporation’s profits. This payment is called dividend.”

A corporation that is making profits or is earning surplus, has two options:

  • Reinvest the surplus or profit in the business.
  • Distribute that surplus or profit among the corporation’s shareholder.

A third thing may happen. The corporation may take a part of the profit it earned (and do whatever it wants, like reinvest in business) and the remaining, it pays out to its shareholders as dividend.

In case you are not aware, dividends are usually correlated with stocks. Since, dividend is given by companies to their shareholders, dividends actually work as a reason why people by stocks of companies that are stable.

Those people who purchase stocks, dividends actually play an important role for them because when a company pays out regular dividends, it works as an indicator that the company is performing well and its foundations are really good.

However,

When it comes to mutual funds, dividends have a slightly different format. In case of mutual funds, unlike in case of stocks, companies never ever pay dividends from their own pocket. Only and only when the companies earn profit, they provide dividends. This means, dividends in case of mutual funds are always paid using the profits earned. So basically, in case of mutual funds, the dividend that is given to you is nothing other than your very own money.

What mutual fund companies will do is that when they are giving dividends (payout or reinvestment), they will simply deduct the dividend value from NAV or Net Asset Value of the stock. This means that the wealth that you have will not increase.

Example:

You invest in a mutual fund scheme where the NAV is INR 20 per unit. You invest enough money to buy 1000 such units at their NAV. Now, by rule of mutual fund, if the scheme is offering dividend of INR 2 to you, it will reduce the NAV by exact same value as the dividend. Hence, the NAV per unit now becomes INR 20 – INR 2 = INR 18.

So, if you have 1000 units, the total wealth as per new NAV is INR 18,000. On the other hand, however, you earned dividend of INR 2 per unit. So, the total dividend you earn is INR 2,000. So, total wealth that you have now is INR 18,000 + INR 2,000 = INR 20,000. This is basically the same wealth you had before the dividend was declared and the NAV was INR 20 per unit.

Now, the big question…

How Does a Mutual Fund Company Declare Dividends?

Only and only when a mutual fund scheme manages to make profits within the portfolio, the company will declare dividends. Now, the question is, how are profits realized? They are realized by the fund managers who book profits by

  • Selling instruments or,
  • When interest or dividends is received by them through debt funds (which are a part of the scheme portfolio).

There is something called paper profits or unrealized profits. Dividends cannot be declared from those profits.

These profits (realized) actually get added to NAV. It is up to the fund manager to decide whether the profits will be reinvested back into the scheme or whether a part of the profits will be announced as dividends. Whatever the fund manager decides actually depends on the scheme objectives as defined.

Dividend Frequency?

This is a very important question. Investors often ask, “at what frequency should one expect dividend payouts from a mutual fund scheme?”

The unfortunate truth about the mutual funds is that dividend payouts are not at all guaranteed and there is absolutely no guarantee that the dividend amount will be fixed either.

However, those that offer dividends can actually provide the same at various frequencies such as:

  • Daily dividends
  • Monthly dividends
  • Quarterly dividends
  • Annual dividends

For instance, there are several monthly dividend schemes where the mutual fund scheme tries to provide dividends on a monthly basis.

What really happens in cases of schemes that offer dividends, the mutual funds house will not allow NAV to grow. Once the NAV hits a specific level, dividends get declared and again, the NAV is pulled down. Because we know that NAV is reduced by the same amount as the dividend declared, the NAV is returned back to previous level.

For instance, you invest in a scheme where the unit NAV is 15. Once the NAV hits 17, the mutual fund will declare dividend of INR 2. This will immediately reduce the NAV back to 15.

Mutual Fund Face Value

When we talk of shares, the Face Value of the share is actually the share’s initial value using which experts forecast the initial value of capital of any company. For example, let us assume that a company releases shares with Face Value of INR 10. There are enough shares whose value will add up to INR 10 lakhs. This means that when the Face Value of a share is INR 10, the total initial equity that the company will have is “number of shares multiplied by the Face Value of each share”. In this case, it is INR 10 x 100,000 = INR 10 lakhs.

Now that we have a quick understanding of Face Value, we need to understand the concept of Market Value. This Market Value is the price at which a share is exchanging hands. This means that even if the Face Value of the share is say, INR 10, it may actually exchange hands at a price say, INR 15. So, INR 15 will be the Market Value of the share while INR 10 is the face value of the share.

From this we can understand that the Market Value can actually change depending on demand and supply – the basic law of understanding.

However, we need to understand one thing – even the Face Value can change. Just how is that possible? The company may actually decide to reduce the price of the share (Face Value) and increase the number of shares in such a way that the initial capital remains unchanged. So, in the example we citied above, think of a situation where the company decides to pull down the Face Value per share to INR 5 and increase the number of shares to 200,000 from 100,000. This will keep the total initial capital intact at INR 10 lakhs.

IMPORTANT POINT: When it comes to stocks and shares – dividend is paid out on Face Value and not on the Market Value.

In terms of Mutual Funds…

There is Face Value of Mutual Funds and it is the price at which mutual funds are listed after NFO or New Fund Offer. In case you don’t know the Face Value of a mutual fund is in general, INR 10.

This Face Value of a mutual fund is always different from the NAV or Net Asset Value. The NAV is basically the price at which the mutual fund is exchanging hands.

Dividends come on Face Value and not NAV. So, when a company actually declares 20% dividend (or whatever percentage actually), that is calculated on Face Value of mutual fund. So, if Face Value is say INR 10 and NAV is 25 for every single unit and dividend declared is 20%, here is what will happen:

Dividend = 20% of Face Value = 20% of 10 = INR 2.

Since, NAV is reduced by the same amount as dividend, the new NAV will be INR 25 – 2 = INR 23.

Let us elaborate the example in further details and include the various forms of mutual funds (that is growth, dividend payout and dividend reinvestment). This will give a greater degree of clarity to you.

NAV and Dividend Example in Mutual Funds

Let us assume that Mr. X wants to invest in mutual funds and wants to start small. His total investment amount is just INR 2,000.

Here are a few assumptions that we are making:

  • The Face Value of the mutual fund is INR 10
  • The NAV at which Mr. X will have to purchase the mutual fund is INR 20.
  • After a year, the NAV of the mutual fund will increase to INR 25.
  • After a year, the mutual fund company will declare dividend of 20%.

With these assumptions in place, here is what we get:

  • X will be able to purchase: INR 2000 / 20 = 100 units.
  • After 1 year, the dividend that will be given to Mr. X is INR (20% of 10) x 100 = INR 200.
  • After 1 year, the NAV will be reduced to INR 25 – INR 2 = INR 23 for every single unit.

In case of Dividend Payout option:

Mr. X will get a dividend of INR 200 and NAV will be reduced to INR 23.

In case of Dividend Reinvestment option:

Mr. X will be given new units against the dividend amount but at new NAV value. This will stand to: INR 200 / 23 = 66.67 (the amount that will be reinvested is INR 200 and the value at which the units will be purchased is INR 23 and hence, the number of units that will be given in total investment amount divided by the new NAV).

In case of Growth option:

In this case since nothing is paid out (that is no dividend is paid out), the NAV will not be reduced and the entire amount will go back into investment. Hence, the NAV will be INR 25 and the actual wealth will increase to INR 2,200.

PLEASE NOTE: In case schemes which are open-ended, the NAV is declared every day and in case of schemes which are closed-ended, NAV is declared every week.

Important Terms Which Are Associated with Dividends Offered in Mutual Funds

Like it or not, it is an ugly truth. When it comes to financial world, you need to deal with a number of jargons and unless and until you are well aware of those terms and their meanings, you will feel lost. So, let’s ensure that such terms do not put us down in any way. When it comes to mutual funds dividends, there are a lot of such jargons. In this section, we will learn about those technical terms.

Let’s begin…

  • Record Date: It is a date on which the mutual fund house records the names of all unit holders to whom the company will be paying out dividend income.
  • Ex-Dividend Date: It refers to that date on which day Net Asset Value of a fund will decline by an equivalent amount to that of the declared dividend. This date always comes after Record Date. There will always be a few days of gap between the Record Date and the Ex-Dividend Date. On the Ex-Dividend Date the mutual fund’s NAV will decline or reduce.
  • DDT: DDT stands for Dividend Distribution Tax. When dividends are paid out, the investors who receive the dividends are not required to pay any tax on the same. However, this isn’t the case with the mutual fund houses. They need to pay a tax for distributing the dividends. This tax is known as Dividend Distribution Tax.
  • Dividend Amount: Technically, this is not jargon. The meaning is straightforward. Dividend Amount is defined as the total dividend paid out to an investor. This amount is determined by multiplying the number of units held by the investor with the dividend declared per unit. So, if the declared dividend is INR 2 and an investor holds 5,000 units, the total Dividend Amount comes to INR 2 x 5000 = INR 10,000.
  • Dividend History: This too is straightforward. It actually refers to the historical records of the dividend declarations by a mutual fund house for it schemes. Dividend History is important because it tells you how a mutual fund has been performing over time or through various market cycles. Remember the good performance during good market conditions is not an indicator of overall good performance. If during market downswings, the mutual fund schemes are performing well and giving good profits and hence, good dividend payouts, the scheme is trustworthy, else, you should look for other schemes. In this context of market cycles, you should know two terms – bull market and bear market. Bull market is when the market is high and returns are high and bear market is when the markets are volatile and has downward trends because of negative sentiments. You need to check out the performance of a mutual fund during the bear market.

Some Important Questions

Question: Is an investor entitled for getting dividends if, he or she purchases the mutual fund scheme on Ex-Dividend Date?

Answer: NO! That is not possible at all. In case a person wants to earn dividend from a particular scheme, he or she needs to ensure that he or she purchases the scheme on or prior to Record Date.

Question: What if a person purchases the scheme a day before Ex-Dividend Date? Will he or she get the dividend?

Answer: YES! The person will be entitled for dividend in such a scenario because the day before the Ex-Dividend Date will also be considered as the Record Date.

Question: The investor decides to sell the fund. He or she however, sells it exactly on the Ex-Dividend Date or after that date. Will the investor get the dividend?

Answer: YES! The investor will still get the dividend because the only position when dividend will not be paid out is when the fund is sold prior to the Ex-Dividend Date.

Finding Dividend History of a Fund

As we said earlier, knowing dividend history helps to understand a fund’s consistency. Hence, you should always check out the history. The question is, “how?” There are many websites out there that provide this information. You can always go and check the website of a particular mutual fund house, find the fund and check out the history of dividends. While this is option is a viable one, the only problem with this option is that you cannot find the history of dividends for other funds from other mutual fund houses. So, a third-party website usually comes in handy because there you can find history of all mutual fund schemes from all mutual fund houses. Some of those websites include:

  • Economic Times.
  • Money Control.
  • Value Research Online.
  • Advisor Khoj etc.

For instance, if you want to check out history of dividends for a particular fund on Money Control, simply follow these steps:

  • Go to Money Control website
  • Type in the name of the fund or scheme in the search box.
  • Click on the fund name.
  • On the left side of the screen, check out the option called ‘Dividend History’.
  • Just click on the option called Dividend History and you shall get the history.

Tax Implications on Mutual Fund Dividends

When it comes to mutual funds, there will be two variants of income:

  • Capital Gains
  • Dividend Earnings

In case of Growth Options, no dividends are paid out and hence, Growth funds only gives capital gains.

In case of Dividend Payout as well as Dividend Redistribution, there’s both dividend income as well as capital gains.

As we mentioned before, investors do not need to pay when it comes to dividend earnings. However, companies (mutual fund houses) are required to pay 28.84% DDT (inclusive of cess and surcharge). This is true only and only for debt mutual funds. When it comes to equity mutual funds, even the mutual fund houses are not required to pay any taxes.

Despite the fact that dividend earnings do not attract taxes for investors, they still need to ensure that they mention the same in their Income Tax Return filing. The income will be shown as dividend income and hence, exempt from tax. The image below will give an idea of what has to be shown in the Income Tax Form:

PLEASE NOTE: Despite the fact that once you receive dividends, you don’t need to pay taxes, you actually effectively pay the DDT. What the mutual fund houses do is that since they need to pay the tax, they will pay DDT based on scheme type and the amount of DDT they pay is then deducted from NAV.

Some Important Points to Note

  • DDT is not applicable in case of equity funds. Equity funds are those funds where the equity allocation is greater than 65%.
  • Starting 2013, June 1, the DDT for debt funds was hiked from 12.5% to 25% (100% increase) for HUFs and Individuals. For any other entity such as company or firm, DDT will stay at 30%.
  • Starting 2014, October 1, authorities have changed DDT calculation procedure. Previous, DDT was calculated based on net dividend and now DDT is calculated based on gross dividend.

Previous and current procedures of dividend calculations are shown below in the table:

Before Budget 2014-2015 New Rule Effective 2014, October 1 (Finance Act 2014, No. 2)
A. Dividend Declared INR 100 A. Dividend Declared INR 100
B. Net Dividend = B = A / (1+DDT) INR 80 B. Net Dividend = A-C INR 75
C. 25% DDT = A – B OR, 25% x B INR 20 C. 25% DDT = A x DDT INR 25

Mutual Funds and Capital Gains

When it comes to capital gains, there are basically two variants:

  • Short Term Capital Gains
  • Long Term Capital Gains

These two variants are dependent on the duration for which an asset is held in possession. If shares that are unlisted and immovable properties stay in possession of someone for a total duration of 36 months or more than that, those assets will be considered as long term assets and the capital gains arising out of those assets is referred to as Long Term Capital Gains. However, if someone holds a listed share for a duration of 12 months, it becomes long term asset and the capital gains from such listed shares is called LTCG.

The table below gives a snapshot of Long Term Capital Gains (LTCG) and STCG or Short Term Capital Gains for equity mutual funds and debt mutual funds:

Asset Type STCG LTCG Tax on STCG Tax on LTCG
Debt Mutual Fund Prior to 2014 August Capital gains gets added to individual’s income and then taxed accordingly as per the tax slab applicable Prior to 2014 August, 20% with indexation and 10% without indexation. Post 2014 August, 20% with indexation
Sold before completion of 1 year Sold after completion of 1 year
Post August 2014 Post 2014 August, 20% with indexation
Sold before completion of 3 years Sold after completion of 3 years
Equity Mutual Fund Sold before completion of 1 year Sold after completion of 1 year Tax applied at the rate of 15% NIL

Okay, now that we are done with the taxation aspect, we are only left with Switching. This is the final part of the article. We will be done after that.

Mutual Funds Dividend Option Switching

There may be condition where you may want to make a switch between the various formats of mutual funds. Basically, this is what you can do:

  • You can switch from dividend option to growth option.
  • You can switch from growth option to dividend option.

Whatever you choose, it will be considered that you are redeeming on option and then you are making a fresh purchase for the other option. The reason for this is simple: NAVs in case of growth option is different from NAVs in case of dividend options. Hence, plain switching at will is simply not possible.

Also remember, when you decided to make such a switch, you may attract:

  • Exit load
  • Capital gains tax depending on how long you held the fund.

The process of switching is very simple. You need to apply for a switch using a form and then wait for 24 hours. Normally switching is completed within 24 hours from the time of application but it may take longer based on certain scenarios and of course, don’t think of switching during weekends.

In case you want to switch between the two dividend options – Dividend Reinvestment and Dividend Payout, all you have to do is fill in what is known as transaction slip or simply provide a handwritten application. The number of units you hold will not change. The only thing that will change is dividend will either be paid out or reinvested depending on what switch you make.

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