Finance Minister Arun Jaitley has introduced a Long Term Capital Gains (LTCG) Tax of 10% for Capital Gains exceeding Rs 1 lakh in a year. This tax will be charged without providing the benefit of indexation.

The LTCG was previously not taxed and that used to encourage investors to invest in equities for long-term i.e more than 1 year. You can get to know more about LTCG tax here.

The introduction of a 10% tax on income distributed by equity funds will affect investors used to earning dividend without paying tax. The dividend distribution tax (DDT) will impact those who have opted for the dividend plan of equity oriented funds. A systematic withdrawal plan (SWP) could be the right option now.

Dividend Mutual Fund:

Dividend Mutual Funds are funds where dividends are given to investors at intervals by the Mutual Fund Company. These funds are just like growth funds, except one difference. In case of growth funds, the earned amount gets reinvested by the mutual fund company whereas in case of dividend funds the amount is paid back to the investors at intervals.

Few important points regarding dividend funds are:

  1. These funds are chosen by investors who want a fixed income at regular intervals. Ex- old people after retirement chose to invest in these type of mutual funds
  2. Tax implication is one of the differentiating factors. Equity dividend funds are not taxable under section 10(23D) while the debt dividend funds are taxable. At the same time equity dividend funds will provide you higher returns, however, they also carry higher risk with them.
  3. Returns that an investor gets in these funds are lower compared to growth funds since here the amount does not get reinvested
  4. The returns are also not given in fixed intervals
  5. The dividends given are also not fixed

An alternative to investing in dividend fund is to invest in Systematic Withdrawal Plan (SWP). In this, a fixed amount can be withdrawal at fixed intervals. Moreover, the frequency and amount of withdrawal can also be selected by the investor.

Over the past few years, many mutual fund companies had been selling the dividend plan of equity-oriented balanced funds to investors as a safe way of earning secure monthly income.

This push to depend on dividend income from equity funds inclined to market volatility put investors on the wrong road say experts. The concern was that these funds would fail to pay dividends if markets rose, leaving investors in a spot.

However, the introduction of a tax on dividend income will now effectively halt fund houses from using such gimmicks, say experts.

Systematic Withdrawal Plan:

Systematic Withdrawal Plan (SWP) will now become more relevant as this scheme will be taken up by investors looking to get a steady flow of income.

SWP is a method of redeeming money from the mutual fund investment in an organized manner, as opposed to getting it all at once. For example, if an investor has invested Rs 50,000 in a scheme, he can set up an SWP to withdraw Rs5,000 every month on a specific date for 10 months.

Investors use SWP for two purposes:

  1. Withdraw money as a regular monthly income: This is often done for generating cash flows after retirement, and this happens from low-risk debt funds.
  2. Avoid the trap of market timing at the time of redeeming the equity mutual fund units: Just as systematic investment plans (SIP) avoid market risk at the time of investment, SWPs lower market risk at the time of redemption.

Few investors use both these methods i.e redeeming from an equity mutual fund from a portfolio of funds using SWP to reduce market-related risks and to generate a daily income too.

There are no specific mutual funds that are looked at as being ‘good’ for SWP. This procedure of redeeming, from a set of funds, can be used depending on the cash flow needs of the investor.

In the case of dividend funds, the amount and frequency of payment of the dividend is decided by the fund manager of the mutual fund.

If you are relying on a fixed amount of money at the end of every month, dividend mutual funds can hamper your plans when they pay an amount below what you need.

In the case of SWP, you get a fixed amount at the end of every month. If the fund’s performance is good, the SWP will last longer. If the performance is poor, it’ll finish sooner. And if your annual withdrawal is less than what the fund generates every year, you can continue earning from this mutual fund forever!

Starting an SWP after a year from purchase of the equity mutual fund will let an investor earn an assured monthly income. Besides, a small retail investor may be able to avoid tax on his profits altogether if the long-term capital gains accumulated on the amount withdrawn under the SWP remains below the Rs 1 lakh threshold.

Read More: Dividend Plan vs SWP. 

Industry Expert’s Views:

Swarup Mohanty, CEO, Mirae Asset Global Investments (India), said, “Systematic Withdrawal Plan is a better option than dividend even without the levy of tax on the latter. Under SWP, the investor can take out an amount matching his specific requirements, while dividend option does not allow him to do that and leaves him at the hands of the mutual fund company.”
The tax on dividends will also affect arbitrage funds, where income generation is already very low. Arbitrage funds provide returns similar to liquid or bond funds but have to face equity-like taxation.

“We may see money going out of arbitrage funds which were a hit in recent years due to tax benefits,” says Amar Pandit, Founder, HappynessFactory.in, a financial planning entity.

Radhika Gupta, CEO, Edelweiss Asset Management, says, “Equity still remains the lowest taxed investment instrument and it will not impact the increasing equity and SIP culture amongst retail investors.”

Industry Experts on LTCG:

The biggest faults are made when something that has the risk is presented as low-risk under the attire of regular tax-free dividends. “Mis-selling is worsened when this product of equity is offered to investors investing in fixed deposit in the higher tax brackets with the tempt that there is no TDS and dividend is tax-free. This will no longer be the case,” says Aashish Somaiyaa, MD & CEO, Motilal Oswal AMC.

Vidya Bala, Head, Mutual Fund Research, Funds India, says, “This will put a halt to the mis-selling as these funds were not being sold for the purpose for which they were made.”

Chandresh Nigam, CEO, Axis Mutual Fund, said, “Expectation of daily income from an equity-oriented mutual fund was not a suitable course. The tax may take away the tempt of dividend income to some extent.”

Both growth and dividend mutual fund schemes gained from zero taxation earlier. This tax on dividends now makes the growth mutual funds desirable as investors can continue to take exemption on capital gains up to Rs 1 lakh. Under the dividend mutual fund, any dividend paid by the scheme will draw in taxation of 10%, irrespective of the amount. The dividend will be subtracted by the mutual funds itself and not taxed in the hands of the investor.

Conclusion:

An investor chasing returns will continue to invest in instruments like mutual funds which continues to provide returns much better than fixed deposits.

Moreover, people investing in fixed deposits were anyway paying a tax of 10-30% on the interest earned. By investing in mutual funds these investors will have to pay a tax of just 10% on much superior returns than what they were earning before.

Many investors started investing in mutual funds after the demonetization. These investors will be comfortable in paying 10% tax, since the returns on mutual funds will offset and make up for the 10% tax to be paid on its capital gains.

Moreover, these investors were not getting any returns on their idle cash. So these returns from mutual funds will be much greater than what they were earning earlier.

The government has aligned their interest along with investors. They also want the market to grow, so that more tax can be collected.

This is the right time for investors since the market has fallen and investors can get mutual fund units at low prices. New investors can also grab this opportunity by entering the market at the right time. Also matured price sensitive investors can make most of this opportunity.

Happy investing!

Disclaimer: views expressed here are those of the author and do not reflect the views of Groww.