Dont go for mutual fund dividend plans now

With the new dividend distribution tax on equity mutual fund coming into force, using dividend plans is injurious to your financial health.

If any of your investments in equity mutual funds are in the dividend reinvestment plans. If they are, you need to change this, because you are losing money by paying needless taxes. This unnecessary waste of money will happen every time the fund(s) pay any dividends after April 1 this year, when the new tax rules on equity mutual funds comes into effect.

In fact, the idea of dividend reinvestment in equity mutual funds is now so nonsensical that mutual funds should be obliged to issue a warning to all investors who are enrolled in such plans. Those investors who track their investments on the free Portfolio Manager at Value Research Online will start getting a warning from us soon, along with tailored advice on exactly what to do.

Unfortunately, there are still a large number of older investments that are in dividend reinvestment mode. This mode became popular a long time ago because it saved taxes. Previously, there was a tax on capital gains but no tax on dividends. Therefore, funds introduced this dividend reinvestment option. In it, all gains were paid out as dividends. Those investors who wanted to have their investments grow took an option whereby dividends were immediately reinvested automatically. In effect, this became a legal stratagem for avoiding capital gains.

Later, tax on equity capital gains was abolished. However, dividend reinvestment continued as an option even though it had no advantage or disadvantage. Many investors were just used to this option and kept choosing it. Now, the tax rules have changed again. There is a 10% tax on both long-term capital gains and dividends. However, the tax on capital gains comes into play only when you actually sell your investment. The tax gets deducted by the mutual funds at source every time when a dividend is paid out, or reinvested. In effect, in the reinvestment option, your money keeps getting reduced. Even though the percentage of tax on capital gains is the same as dividend, your eventual returns will be severely impacted because the dividend tax constantly reduces the amount available for further growth.

Many investors do not realise that fund dividends and company dividends are two different things. Funds can pay dividends, or not pay them, regardless of whether they receive dividends from their investments. In fact, this is one of the least understood aspect of mutual fund investing in India. And it is not just accounting trivia--it's actually the source of some bad decisions about investing.

In mutual funds, capital gains, dividends and interest income can get interconverted. Mutual funds invest mostly in equity assets and in bonds. Both types of assets yield capital gains (or losses). Apart from that, bonds generate interest income, and equity can generate dividend income. However, in the books of mutual funds, all three become part of a single pool of assets. From the investors' perspective, this pool of assets is represented by a fund's NAV. However, mutual funds are free to optionally distribute the gains made on these assets as dividend. It does not matter whether these gains are capital gains, or interest income. They can be distributed as dividend. As a matter of fact, they can also be distributed as 'bonus', but that's generally used only by debt funds.

All these forms of income--capital gains, dividends, interest, and bonus have different taxation norms. However, when you invest through mutual funds, you can simply pick up a growth or a dividend or a bonus plan and have the gains delivered to you in whatever form is convenient to you.

However, this also leads to a peculiar problem. The fact that mutual fund dividends are not dividends at all leads to some bad decisions. To the investor, the word dividend brings to mind corporate dividends, which are indicative of how profitable a company is and how much of the profits are being distributed to shareholders. But in mutual funds, dividends are just a withdrawal from your own account. If the value of your investment in a mutual fund is Rs 1 lakh, and then the fund gives you Rs 5,000 dividend, the value of that investment will be reduced to Rs 95,000. There is no additional benefit at all. As we saw above, a mutual fund dividend just means withdrawing some of the money that was yours anyway and giving it to you.

In fact, even if you need a regular payout from your fund investments, the dividend plan makes little sense. You should invest in a growth plan and just withdraw money as needed. In a dividend plan, the amount and frequency of the payouts is not according to your needs. Why pay tax on withdrawals you may not need at that point?

All things considered, the dividend plans of mutual funds serve no purpose at all except to confuse customers and lead them to bad investment choices.