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No Dividend Distribution Tax for Debt Funds?

The Direct Tax Code has no DDT for debt or non-equity funds. Currently, for liquid funds, dividends are taxed at 25% plus the surcharge and cess, which adds up to nearly 28.5%. (Which I argue is still better than a fixed deposit)

So what’s the catch? Dividends will be taxed for non-equity funds, as if they are your income. Plus, there’s a dividend “withholding tax” – a sort of Tax Deducted at Source – 10% for residents (for >10K dividend), 20% for NRIs and companies.

That makes dividend income equivalent to a fixed deposit, where you get paid a certain amount of interest every year and the bank holds back 10% as TDS. It also makes life more cumbersome – you now need TDS confirmations for each non-equity mutual fund (dividend option) that you hold. (Luckily, now the system is automated, so your TDS credit is visible online. Register here.)

Impact: Growth Plans will make more sense to the investor. Even if you want regular income, just sell regularly, and that gets qualified as either a short term gain or a long term gain depending on how long you’ve held. Short term gains on non equity funds get taxed at your marginal rate too, but have no withholding tax, which is better for cash flow. Long term gains give you indexation benefits for inflation, which is great for debt funds. For a return of 8%, if 6% is inflation, you will pay tax on 2% – again, much better than FDs where you pay tax regardless of inflation.

Example: Take a fund or FD that makes 1% a month, and you put 50 lakhs in it. Assume you’re in the 30% tax bracket.

Investment Interest Withheld What you get

Tax Pd later

Net Return

Fixed Deposit 50,000 5,000 45,000 10,000 35,000
Fund (Dividend) 50,000 5,000 45,000 10,000 35,000
Fund (Growth) 50,000 0 50,000 150 49,850

This is for the first month, since your gain is very little. If you buy 500,000 units at Rs. 10 each, the NAV would have gone up to Rs. 10.1, you will sell 4950 units to get your Rs. 50,000 – that has 49,500 of principal and Rs. 500 of capital gain. Tax at marginal rate = Rs. 150.

As the gains increase, the tax amount goes up, steadily (since now more of the return is gain). But after about 24 months – the longest you need to hold for going into the “long term” bracket – you get the first 6% free of tax due to indexation, and are only taxed on what’s above that (again, at your marginal rate). In the 25th month, the same 50,000 will consist of 10,600 gain and remaining as principal – yet, the long term gain concept keeps that tax at only 2,500. That is far cheaper than the mutual fund (dividend) or FD, where the total tax is Rs. 15,000 every month.

That means: Monthly Income Funds need to be relooked. So does every non-equity fund where dividend was used as an option. With the 10-20% equity kicker in them, they make sense for a reasonable income plan, but the monthly income as dividends will be taxed at a high rate. You might want to use the growth plans instead.

Downside: You need to have the discipline to sell every month, and you’ll need some work in the year to calculate your tax liability. The difference, though, is substantial, even at the 10% marginal tax bracket.

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