Dividend-paying mutual funds hold a fascination for many investors, especially those who want natural cash-flows from their investments. Though many mutual fund schemes have attractive dividend pay-out track records, investors need to understand that mutual fund dividends are not guaranteed. Mutual fund dividends are paid out at the consideration of the fund manager and fund house.
Mutual fund Systematic Withdrawal Plan has added an option for investors to get fixed cash-flows from their purchases. Though dividend and SWP may seem like there are important differences between the two, which we will discuss in this blog column. Of particular importance is the tax consequence of the two because relevant taxation changes were announced in last year’s Union Budget.
How do mutual funds handle dividends?
Mutual fund dividends are not guaranteed, but a deeper understanding of how dividends are paid will help you make informed financing decisions.
As per SEBI, mutual fund dividends have to be paid from the accumulated savings of the scheme. Investors need to understand that accumulated profits must be realized profits. Fund managers cannot pay dividends simply because the NAV has enjoyed. He/she can pay dividends only from profits realized by selling assets at a higher price than the purchase price.
Investors should also realize that the fund manager may not distribute the entire profits booked as dividends. He/she may keep a portion of gains realized in a reserve and only pay a part of the profit as dividends. They do this so that they remain to pay dividends from the accumulated profits reserve during periods where the scheme may not have received profits. If there is no money left in concentrated profits reserve, the scheme will not be able to pay dividends till such time they make acquisitions through portfolio churning.
What is a Systematic Withdrawal Plan?
In a mutual fund SWP, you can draw a fixed amount from your mutual fund investment every month or at any other repetition (specified by the investor); you can specify the amount to be withdrawn and the day of the month when the withdrawal should be made and the amount will be credited directly to your bank account on the stipulated day. You can continue your SWP as long as there are surplus units in your mutual fund scheme account.
How does a Systematic Withdrawal Plan work?
Once the SWP in a certain account (scheme) is received, it generates cash-flows for investors by covering units of mutual fund scheme at specified intervals. The number of units delivered to generate cash-flows in an SWP depends on the SWP amount and the project Net Asset Values (NAV) on the withdrawal dates. Let us learn how SWP generates cash-flows for investors with the help of an example.
Let us assume you spent Rs 10 lakhs in a mutual fund scheme. The purchase NAV was Rs 20; so 50,000 units will be assigned to you. Let us assume you commence a monthly SWP of Rs 6,000 after one year from the date of investment to bypass exit loads. In the first period of the SWP, the scheme NAV is 25. To generate Rs 6,000 for you, the asset management corporation (fund house) will redeem 240 units (Rs 6,000 divided by 25). Your balance systems will be 49,760 (50,000 minuses 240). In the second month, if the NAV is 27, the AMC will purchase 222.22 units (Rs 6,000 divided by 27) for the SWP and your assembly balance will be 49,537.78 (49,760 minuses 222.22 units). In the third month, if the design NAV is 28, the AMC will cover 214.28 units and your unit surplus will be 49,323.49. In SWP your unit balance will decrease with each SWP installment, but if the NAV keeps growing at a faster rate than your abandonment rate, then you can continue your SWP and at the corresponding time see appreciation in the value of the residual units.
Assessment of dividends – Equity Funds
The assessment of dividends has undergone a lot of change over the last few years. For the sake of clearness, we will only cover the taxation of equity funds & equity-oriented hybrid stores in this post.
A few years back, equity fund dividends were completely tax-free, in other words, dividends were tax-free in the hands of the investors and the fund house did not have to give Dividend Distribution Tax before distributing dividends to investors. In the 2018 Budget, the Government organized 10% DDT on equity fund dividends, but dividends extended to be tax-free in the hands of the investors.
In the 2020 Budget, the Government removed DDT but now dividends will be taxed in the support of the investors based on their income tax slab. So for this financial year (FY 2020-21) and beyond, all mutual fund dividends will be combined with your income and taxed according to your income tax slab charge.
For example, if you are in the 30% tax slab, then all mutual fund distributions received by you will be taxed @30% plus appropriate cess/surcharge. Income tax computation will be a little confused this year because you have the option of choosing the new tax management (with very few deductions) or the old tax regime (with all the applicable deductions). You should discuss with your tax advisor with regards to the actual tax outcomes of your mutual fund dividends.
Assessment of SWP – Equity Funds
In SWP, cash-flows are generated by purchasing units. If units are redeemed at a NAV higher than the purchase price, capital increases taxation applies. Units redeemed within 12 months from the date of procurement will be subject to short term capital gains tax @ 15%. Monetary advisors often recommend that investors begin their SWP at least 12 months after the investment date to withdraw short term capital gains tax. Units redeemed after 12 months from the date of marketing will be subject to long term capital gains tax.
Long term capital gains assessment has also undergone some changes over the past few years. Before the 2018 Budget (FY 2018-19), long term capital gains were tax-free. In the 2018 Budget, the Government provided up to Rs 100,000 long term capital gains in a business year to be tax-free. Long term capital increases above Rs 100,000 will be taxed at 10%. If you obtained your mutual fund units before 1st February 2018, the capital increases till 1st February 2018 will be grandfathered, in other concepts, the purchase price of your members will be based on 31st January 2018 NAV of the scheme, irrespective of the amount you bought the units.
Tax support of SWP over dividends
An important part for investors to write about in SWP taxation is that, unlike dividends, the complete SWP proceeds will not be taxed – only the capital gains portion will be taxed. For instance, let us assume that the purchase NAV of your project is Rs 100 and the redemption NAV is Rs 120. You redeemed 1,000 units to make a cash-flow of Rs 120,000. Out of this Rs 120,000 only Rs, 20,000 will be subjected to long term capital gains tax.
Over a period of time in your SWP security, the long term capital gains portion will rise with rising in NAV, but even then it will be much lower than dividend assessment, for investors in the higher tax brackets, because long term capital gains will be charged at only 10% after the Rs 100,000 exemption, while dividends will be charged as per your tax rate e.g. 30% for investors in that bracket.
Which is better and safer - Dividends or SWP?
There are pros and cons of both depending on your economic situation and investment experience:-
One of the most significant points about SWP is that the withdrawal rate should be more moderate than the average long term return of the scheme if you want to extend your SWP for a long time. The withdrawal rate will also depend on what you really require. You should discuss with your financial advisor to plan your SWP according to your needs.