This article focuses on the dividend income from mutual funds - when is it worth opting for a dividend option? How does one keep track of dividends earned, and what are the tax implications?
The focus, when discussing mutual funds as an investment option, is usually on the increase in a fund`s NAV - that is, the growth in capital. And correctly so since this is the primary return the product delivers. But a mutual fund also offers an opportunity to earn a part of these returns in the form of regular, tax- free dividends. For a long-term investor in mutual funds, it is therefore important to understand the dividend option available in funds, their impact on the size of holdings (units) and the taxation on earnings from these investments.
Choosing a dividend option
All mutual funds have three plans on offer:
a) Dividend payout: Here, the dividend declared by the fund is paid out to the investor. Once the dividend has been declared and paid out, the NAV reduces by the corresponding amount. Example, if the NAV is Rs. 30 and a dividend of Rs. 5 per unit has been declared, the NAV reduces to Rs. 25. This option is suitable for investor seeking periodical income in form of regular profit booking in the fund.
b) Dividend reinvestment: The units equivalent to the value of the dividend declared are added to the folio. Here too, the NAV reduces but the number of units held increase. Example: suppose you own 100 units of NAV Rs. 30 and the fund declares a dividend of Rs. 5 per unit, giving you a dividend sum of Rs. 500. This amount will be used to purchase new units of the fund at the reduced NAV of Rs. 25, giving you a total of 120 units in your folio. This option is suitable for investors who do not require intermittent cash but wish to receive profits from the fund at intervals.
c) Growth option, where the dividend value is not deducted from the fund`s corpus, but is reinvested -leading to higher NAV values. All data available on returns delivered by funds is always based on the Growth option. This option is suitable for investors who not require cash and are willing to hold their investments for long term.
By default, assuming that investment is made with the intention of capital appreciation, the growth option is most suitable for investors. However, depending on the life stage of the investor, or taxation and asset reporting requirements, a dividend option might be more appropriate. We explain the two dividend options.
Dividend Payout
This option is most suitable for investors at a higher life stage, where regular income in the form of dividends is desirable. This is also considered to be a method of profit booking, useful in times of volatile markets.
A lot of investors also use the dividend payout option as a method of portfolio rebalancing. For example, if the initial investment is made heavily in debt and balanced funds for a conservative investor, the dividends received can be used to invest in equity funds. This becomes a systematic way to introduce equity exposure for the investor without putting the initial capital at risk.
However it is important to note that in terms of pure capital appreciation this option would be the least rewarding option since the initial capital investment does not get the benefit of compounding (as is the case with growth option).
Dividend Reinvestment
From the point of view of returns, the dividend reinvestment option does not perform very differently from the growth option in the long term. In most cases we find investors using the dividend reinvestment option when purchasing tax saver (ELSS) funds. Additional units added to the folio from dividends are considered to be fresh investments into the fund, giving investors greater exemption under Section 80C.
Example, if you initially invested Rs. 60,000 at an NAV of Rs. 20 (3000 units) and a dividend of Rs. 5 was declared. The dividend value of Rs. 15,000 will be used to purchase an additional 1000 units (at the ex-dividend NAV of Rs. 15). This Rs. 15,000 will be considered as fresh investment under Section 80C, giving you a total tax exemption of Rs. 75,000.
However, it is important to note that tax saver funds carry a lock-in period of 3 years, and a dividend reinvestment option would mean that every fresh set of units added would be locked in for further three years. Exiting such a fund completely at one point of time would therefore be difficult.
Tracking dividend income
Fundsupermart.com allows you to view dividends received as part of your holdings report. The My Investments > View Holdings module enables you to see an overview of your holdings; this table includes information on dividends received as well.
The focus, when discussing mutual funds as an investment option, is usually on the increase in a fund`s NAV - that is, the growth in capital. And correctly so since this is the primary return the product delivers. But a mutual fund also offers an opportunity to earn a part of these returns in the form of regular, tax- free dividends. For a long-term investor in mutual funds, it is therefore important to understand the dividend option available in funds, their impact on the size of holdings (units) and the taxation on earnings from these investments.
Choosing a dividend option
All mutual funds have three plans on offer:
a) Dividend payout: Here, the dividend declared by the fund is paid out to the investor. Once the dividend has been declared and paid out, the NAV reduces by the corresponding amount. Example, if the NAV is Rs. 30 and a dividend of Rs. 5 per unit has been declared, the NAV reduces to Rs. 25. This option is suitable for investor seeking periodical income in form of regular profit booking in the fund.
b) Dividend reinvestment: The units equivalent to the value of the dividend declared are added to the folio. Here too, the NAV reduces but the number of units held increase. Example: suppose you own 100 units of NAV Rs. 30 and the fund declares a dividend of Rs. 5 per unit, giving you a dividend sum of Rs. 500. This amount will be used to purchase new units of the fund at the reduced NAV of Rs. 25, giving you a total of 120 units in your folio. This option is suitable for investors who do not require intermittent cash but wish to receive profits from the fund at intervals.
c) Growth option, where the dividend value is not deducted from the fund`s corpus, but is reinvested -leading to higher NAV values. All data available on returns delivered by funds is always based on the Growth option. This option is suitable for investors who not require cash and are willing to hold their investments for long term.
By default, assuming that investment is made with the intention of capital appreciation, the growth option is most suitable for investors. However, depending on the life stage of the investor, or taxation and asset reporting requirements, a dividend option might be more appropriate. We explain the two dividend options.
Dividend Payout
This option is most suitable for investors at a higher life stage, where regular income in the form of dividends is desirable. This is also considered to be a method of profit booking, useful in times of volatile markets.
A lot of investors also use the dividend payout option as a method of portfolio rebalancing. For example, if the initial investment is made heavily in debt and balanced funds for a conservative investor, the dividends received can be used to invest in equity funds. This becomes a systematic way to introduce equity exposure for the investor without putting the initial capital at risk.
However it is important to note that in terms of pure capital appreciation this option would be the least rewarding option since the initial capital investment does not get the benefit of compounding (as is the case with growth option).
Dividend Reinvestment
From the point of view of returns, the dividend reinvestment option does not perform very differently from the growth option in the long term. In most cases we find investors using the dividend reinvestment option when purchasing tax saver (ELSS) funds. Additional units added to the folio from dividends are considered to be fresh investments into the fund, giving investors greater exemption under Section 80C.
Example, if you initially invested Rs. 60,000 at an NAV of Rs. 20 (3000 units) and a dividend of Rs. 5 was declared. The dividend value of Rs. 15,000 will be used to purchase an additional 1000 units (at the ex-dividend NAV of Rs. 15). This Rs. 15,000 will be considered as fresh investment under Section 80C, giving you a total tax exemption of Rs. 75,000.
However, it is important to note that tax saver funds carry a lock-in period of 3 years, and a dividend reinvestment option would mean that every fresh set of units added would be locked in for further three years. Exiting such a fund completely at one point of time would therefore be difficult.
Tracking dividend income
Fundsupermart.com allows you to view dividends received as part of your holdings report. The My Investments > View Holdings module enables you to see an overview of your holdings; this table includes information on dividends received as well.
Illustration 
Note: The funds depicted in this image are purely for illustration, and are not meant to be a recommendation or a solicitation to buy any or all of them. NAVs depicted in the table are as at 29 September 2010.
In the image, we see that the HDFC Tax Saver Fund has received dividend of Rs. 504.52. Note the following in the table:
1. Since this is a Dividend Reinvestment option, the units in the Holding Quantity table include the additional units added by the dividend being reinvested
2. The Cost column is the original NAV at the time of initial investment
3. The Book Value is the original investment (Rs. 5000) plus dividend reinvested (Rs. 504.52)
4. The Market Price is the current post-dividend NAV
5. The Market Value is the value of the total number of units at the current post-dividend NAV
For Dividend payout options, the amount of dividend paid out will be listed in the Dividend column. The Market Price column will list the current post-dividend NAV and the Market Value column will show the value of the units held at the current post-dividend NAV.
The mutual fund company whose funds you hold also sends you regular account statements that include information on your dividend income. In the case of non-equity funds, the statement will also include information on the distribution tax paid by the fund on the dividend declared.
Tax Treatment
All dividends are tax free in the hands of the investors. However, fund houses have to pay a dividend distribution tax for dividends declared on non-equity funds, where equity funds are defined as having 65% or more of their corpus invested in equities. The Dividend Distribution Tax (DDT) rate for debt funds (other than liquid funds) is 13.84% and for liquid funds is 27.68% (inclusive of surcharges and cess). This tax amount is paid by the mutual fund itself and you receive the dividend net of DDT.
It is worthwhile to note that in the upcoming Direct Tax Code, which will be applicable from April 2012, a change has been proposed in the tax treatment for dividends on mutual funds. Dividends distributed by equity funds will attract 5% DDT, but will continue to remain tax free in your hands. Dividends distributed by non-equity funds will attract no DDT but will be considered as taxable income in your hands. Confirmation and further clarity on these proposals should be available once DTC comes into force.
Conclusion
Your needs as an investor may be unique yet, it is important for you to understand all the available options and get the best possible fit. Dividend plans available under mutual funds offer regular, tax-free income that can be used to supplement your income, reduce your tax liability or make further investments as required. Happy investing!
Note: The funds depicted in this image are purely for illustration, and are not meant to be a recommendation or a solicitation to buy any or all of them. NAVs depicted in the table are as at 29 September 2010.In the image, we see that the HDFC Tax Saver Fund has received dividend of Rs. 504.52. Note the following in the table:
1. Since this is a Dividend Reinvestment option, the units in the Holding Quantity table include the additional units added by the dividend being reinvested
2. The Cost column is the original NAV at the time of initial investment
3. The Book Value is the original investment (Rs. 5000) plus dividend reinvested (Rs. 504.52)
4. The Market Price is the current post-dividend NAV
5. The Market Value is the value of the total number of units at the current post-dividend NAV
For Dividend payout options, the amount of dividend paid out will be listed in the Dividend column. The Market Price column will list the current post-dividend NAV and the Market Value column will show the value of the units held at the current post-dividend NAV.
The mutual fund company whose funds you hold also sends you regular account statements that include information on your dividend income. In the case of non-equity funds, the statement will also include information on the distribution tax paid by the fund on the dividend declared.
Tax Treatment
All dividends are tax free in the hands of the investors. However, fund houses have to pay a dividend distribution tax for dividends declared on non-equity funds, where equity funds are defined as having 65% or more of their corpus invested in equities. The Dividend Distribution Tax (DDT) rate for debt funds (other than liquid funds) is 13.84% and for liquid funds is 27.68% (inclusive of surcharges and cess). This tax amount is paid by the mutual fund itself and you receive the dividend net of DDT.
It is worthwhile to note that in the upcoming Direct Tax Code, which will be applicable from April 2012, a change has been proposed in the tax treatment for dividends on mutual funds. Dividends distributed by equity funds will attract 5% DDT, but will continue to remain tax free in your hands. Dividends distributed by non-equity funds will attract no DDT but will be considered as taxable income in your hands. Confirmation and further clarity on these proposals should be available once DTC comes into force.
Conclusion
Your needs as an investor may be unique yet, it is important for you to understand all the available options and get the best possible fit. Dividend plans available under mutual funds offer regular, tax-free income that can be used to supplement your income, reduce your tax liability or make further investments as required. Happy investing!
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