Stay away from the comfort and lure of Tax-free Dividends!

Posted By : Kushal Kothari
Tags :  Tax Growth Dividends

Money in the bank account feels good, doesn't it? Even better if it is tax-free! That's one of the biggest reason why hundreds of thousands of investors in mutual funds invest in dividend schemes. We felt we really need to put a point across to investors who don't fully understand how dividend schemes work. A lot of the so-called benefits are nothing but tactics that appeal to emotions rather than any logic. 


1. How do dividend schemes work?

For an investor, there are only two ways to get returns on investment. Either the value of the investment (NAV) grows, or the investments starts paying back money (Dividends). 

In Dividend option, as the name suggests, dividends are paid out i.e., periodically a part of your investment is put back in your bank account. However, this results in a lower NAV

In Growth option, all dividends received from the investments are reinvested, which result in a higher NAV. 

The bottom line is this. Choosing growth and dividend option offers the same returns when you take in account the NAV returns and dividends paid out. However, in the growth option, your money is constantly put to work by reinvesting which may otherwise lie idle in a savings bank account earning a return of just 4%. Be it in your bank account or mutual fund account, it is always your own money!


2. Breaking the myths

There are a couple of reasons why people go for dividend option (or are sold so by their agents)

Volatility - It is assumed that dividend schemes have less volatility a.k.a Risk. Mathematically, it is completely true. As part of the investment is coming back to your account, where it lies dead, the volatility of the portfolio reduces. As they say, what is dead never moves. But what is dead, also never grows. And growth is the primary reason for investing right? If the same money is to be reinvested, the risk associated with a growth and dividend schemes becomes absolutely the same!


Returns - We've already discussed this above. The total returns due to an increase in NAV and dividends is what we need to consider when looking at returns. Many investors have been lured by the 1% per month dividend that many debt schemes offer. However, when you look at the NAV, it may actually be lower than when you invested in the scheme. In other words, the dividends you receive are nothing but your principal investment being returned back to you. A neat trick isn't it? 


Tax efficiency - Here's the big daddy of all misunderstandings. We all are sold the concept of tax-free dividends so hard, that we don't even bother to understand how taxation works in the first place. We've already detailed some of the aspects here. Since this is a slightly tricky thing to understand, let's break it into two parts


Equity Schemes: Dividends in Equity schemes are tax-free. But all returns in equity schemes are completely tax-free after a year anyways. Think about it. The reason to invest in equities is growth, then why even bother cashing out the growth? Also, it makes absolutely no sense to invest in equities with a horizon of fewer than 3 years at the minimum. Anything you sell after a year is tax-free anyway! 

Equity schemes taxation


Debt Schemes: This is even trickier. Even if the dividends from debt scheme are tax-free for you, the fund manager pays a 28% tax (including services taxes) even before the dividend is passed on to you. This effectively reduces the NAV of the fund and hence the total return for the investors. Effectively, the investor ends up paying a 28% tax in dividend schemes of Debt funds regardless of his incomes levels. Growth schemes are however different. The tax you pay depends on when you redeem the schemes. Refer to the table below

Debt schemes taxation

Notice the yellow cells above? That is the only case when it makes sense to invest in dividend scheme rather than growth scheme. So if you are an investor in debt scheme, in the 30% tax bracket and intend to sell your holdings in less than 3 years, only then it makes sense to invest in dividend schemes. And this is assuming you'll be reinvesting your dividends and not let them die in the savings account!


The pension argument! - Finally, many people, especially the elderly like to have a pension in the account to take care of monthly expenses. As explained above, it still makes sense to withdraw from growth schemes when required or even better, initiate a Systematic Withdrawal Plan (SWP). The benefits of both, growth option and a pension too!


3. Conclusion

Dividends by themselves do not have any added value other than an emotional comfort of money coming back to your account. Financially, they generally end up being the inferior option. Even if you need money at a periodic frequency, an SWP makes much more sense than investing in a dividend option. As a rule of thumb - Invest in Direct plans, Invest in Growth plans


Happy Investing!