Rule: To avoid dividend distribution tax on payouts from debt-oriented funds, one should go for the growth option, not the dividend option.
Exception: Pick the dividend option if you are in the highest tax bracket and your investment horizon is less than a year. The DDT payable on income will be lower than the tax you will have to pay on short-term capital gains.
25 per cent is the DDT on payouts by liquid funds, which invest primarily in the call money market. The funds with more than 65 per cent invested in equities are exempt from DDT.
15 per cent is the DDT on dividend paid by companies to their shareholders. The Direct Taxes Code proposes a 15 per cent DDT on payouts by equity-oriented mutual funds as well.
Short-term capital gains from non-equity mutual funds are added to the income of the investor and taxed at marginal rate. This significantly reduces the returns of investors in the highest tax bracket. In the example below, the investor stands to gain if he goes for the dividend option.
The dividend advantage | ||
|---|---|---|
Dividend option | Growth option | |
Investment | 1,00,000 | 1,00,000 |
Dividend received | 3,182 | Nil |
Value after 6 months | 99,045 | 1,02,716 |
Profit earned | 2,227 | 2,716 |
Tax on capital gain | Nil | 814 |
Post-tax return | 2,227 | 1,902 |
| All figures in Rs; investor assumed to be in 30 per cent tax bracket | ||
Apart from the higher returns earned from the dividend option, the notional short-term capital loss of Rs 955 booked by the investor after six months can be set off against any other shortterm capital gain. For instance, if he makes a short-term profit of Rs 1,000 on any other investment, including equities, he will have to pay tax only on Rs 45.
Currently, such short-term losses can be carried forward for up to eight financial years. However, the draft Direct Taxes Code has proposed that investors be allowed to carry forward such losses indefinitely. This provision could make the dividend option in mutual funds the preferred choice for investors in the highest tax bracket.
