Looking to invest in mutual funds for dividends? Here’s how dividends in equity

Pranati Deva
Updated: 13 Dec 2021, 05:11 PM IST
TL;DR.

A lot of investors invest in mutual funds to generate regular dividends. But it is important to understand how they will be taxed. Let’s take a look

One must keep in mind that dividends from mutual funds are taxed and it is important to clearly understand the tax implications of these dividends.

One must keep in mind that dividends from mutual funds are taxed and it is important to clearly understand the tax implications of these dividends.

Investing in mutual funds has many benefits, dividends is one of them, if you opt for it. A number of investors choose to invest in dividend-bearing mutual funds to get regular cash flow throughout the year.

Mutual funds pay dividends out of the returns generated by the firm. Since these are paid out of the received interest by stocks and bonds, there is no fixed amount which an investor will receive. It depends on the returns.

But one must keep in mind that these dividends are taxed and it is important to clearly understand the tax implications of dividends from both equity funds as well as debt funds.

Dividends are taxed at different rates for both types of funds. First, let's be clear about how to differentiate between these two.

Any fund with over 65 percent of assets under management in stocks or equity will be classified as an equity fund, otherwise, it will be a debt fund. Hence, sector funds, index funds, diversified funds, arbitrage funds, multicap funds and mostly even balanced equity funds come under equity funds for tax purposes. Meanwhile, liquid funds, short-term funds, ultra short-term funds, bond funds, credit funds, MIPs, and FMPs, are debt funds.

Now let's look at how dividends of these funds are taxed:

As per amendments made by the Union Budget 2020, the dividends are now taxed at the hands of the investors. The dividends for both equity and debt funds have not been declared taxable income and thus will be charged on the basis of the income tax slab of the investor.

However, an individual can claim a deduction in income tax under section 87A, if the total dividend income in a financial year is less than 5 lakh.

“It is proposed to carry out amendments so that dividend or income from units are taxable in the hands of shareholders or unitholders at the applicable rate and the domestic company or specified company or mutual funds are not required to pay any DDT. The incidence of the tax should, therefore, be on the recipient and not on the payer or the mutual fund,” Finance Minister Nirmala Sitharaman announced during the Union Budget 2020.

So if your tax slab is lower, your dividends will be taxed less as compared to an investor with a higher tax slab.

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Understanding taxation on mutual fund dividends

Investing in mutual funds has many benefits, dividends is one of them, if you opt for it. A number of investors choose to invest in dividend-bearing mutual funds to get regular cash flow throughout the year.

Mutual funds pay dividends out of the returns generated by the firm. Since these are paid out of the received interest by stocks and bonds, there is no fixed amount which an investor will receive. It depends on the returns.

But one must keep in mind that these dividends are taxed and it is important to clearly understand the tax implications of dividends from both equity funds as well as debt funds.

Dividends are taxed at different rates for both types of funds. First, let's be clear about how to differentiate between these two.

Any fund with over 65 percent of assets under management in stocks or equity will be classified as an equity fund, otherwise, it will be a debt fund. Hence, sector funds, index funds, diversified funds, arbitrage funds, multicap funds and mostly even balanced equity funds come under equity funds for tax purposes. Meanwhile, liquid funds, short-term funds, ultra short-term funds, bond funds, credit funds, MIPs, and FMPs, are debt funds.

Now let's look at how dividends of these funds are taxed:

As per amendments made by the Union Budget 2020, the dividends are now taxed at the hands of the investors. The dividends for both equity and debt funds have not been declared taxable income and thus will be charged on the basis of the income tax slab of the investor.

However, an individual can claim a deduction in income tax under section 87A, if the total dividend income in a financial year is less than 5 lakh.

“It is proposed to carry out amendments so that dividend or income from units are taxable in the hands of shareholders or unitholders at the applicable rate and the domestic company or specified company or mutual funds are not required to pay any DDT. The incidence of the tax should, therefore, be on the recipient and not on the payer or the mutual fund,” Finance Minister Nirmala Sitharaman announced during the Union Budget 2020.

So if your tax slab is lower, your dividends will be taxed less as compared to an investor with a higher tax slab.

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Before this, dividends distribution tax was applicable on mutual fund dividends. Equity fund dividends were taxed at 10 percent. Along with this tax, a surcharge and cess were also deducted and only the remaining net amount is paid to the investors. Dividends were then tax-free at the hands of the investors only at the source. This meant that once investors received dividends (minus the tax), there was no further tax applicable on it.

Similarly for debt funds, the tax was deducted at the source and not at the hands of an investor. However, the dividend distribution tax was higher for debt funds as compared to equity funds. Debt fund dividends were taxed at 25 percent. Extra surcharge and cess are deducted for debt fund dividend also, same as equity funds.

As per experts, the new tax regime is more beneficial for investors who want to invest in debt funds with the dividend option and for smaller investors (with low tax slabs) who require regular cash flows.

Now that we know and understand how dividends are taxed for both equity and debt funds, you should consider the dividend only if you need regular extra income. Growth option in mutual funds is a better option with higher tax benefits.

First Published: 13 Dec 2021, 05:11 PM IST
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