Removal of Dividend Distribution Tax: How will you get impacted??

Nirmala Sitharaman presented the Union Budget 20-21 on the 1st of February wherein, she announced the removal of Dividend Distribution Tax (DDT) and made dividends taxable on the hands of the investor. DDT stood at 11.65% after surcharge and cess which was lower than the Short Term Capital Gain at 15.6% but slightly higher to the 10.4% Long Term Capital Gains. So it made perfect sense for the investor to choose the dividend option and cut-off the STCG and LTCG on equity mutual funds.

How will this change impact the investors in various tax slabs?

But with the removal of DDT, the investors are now going to pay the dividend tax based on their respective tax slab. People in the lower tax bracket can still stick to the dividend plan as the removal of DDT won’t have any significant or negative impact on them and can use the dividend plan to manage cash flow. But since most of these investors are from the higher tax brackets, it no longer makes sense to remain in the dividend option as you would end up paying more tax and won’t be able to see any return on your money. The better alternative now would be the growth option which is taxed on the capital gain based on the holding period.

Better alternative for high tax bracket investors

Systematic Withdrawal Plan (SWP) on the growth option should be used for predictable cash flow instead of the dividend because, after the tax deduction, the investor will have a higher return. Another great reason for choosing the growth option in the convenience of the withdrawal. Unlike dividends, which are declared by the mutual fund company, investors can decide when to book profit in growth options.

Let’s compare 2 cases where investment period is assumed for 1 year and 6 months respectively and see what is the difference in the effective yield in the growth plan and dividend plan. The fund used for example is HDFC arbitrage fund with the total lumpsum investment made of Rs. 1 Lakh.

In the above table, if the entire year’s gain is 6%, the current value of the lumpsum investment would become Rs. 1,06,000 giving you a dividend pay-out of Rs. 6,000. Now, if you fall in the highest tax bracket you would end up with only Rs. 3,439 now as opposed to Rs. 5,301 which you would receiving had the DDT not been abolished. Now, if the same amount was invested in the growth plan and the excess was withdrawn as per the recommended SWP, you will be entitled to pay LTCG on the capital gain which would amount to Rs. 633. This will give you Rs. 5367 compared to the Rs. 3439 according to the dividend plan. Thus, giving you 56% more money in the growth plan.

The other case taken above is the investment for 6 months which is basically to show the difference in the effective yield comparing the new DDT based on tax slabs and STCG which is applicable to the growth plan where redemption is done in less one year. Here, the 6 months return for the fund in 2.63%. The current value of the lumpsum investment in Rs. 1,02,630, giving you a dividend payment of Rs. 2,630. So, currently you would be receiving Rs. 2,324 after the tax deduction. But after the change is in effect you will be receiving only Rs. 1,507. Now, if the same investment was done in the growth plan and the capital gain was withdrawn, you will be entitled to pay Rs. 438 as per STCG giving you Rs. 2,192 after the deduction. So, in the growth plan you will receive Rs. 2,192 as compared to Rs. 1,507 which is 45% more money.

TDS: Cutting the thin string attached to the dividend option

The minister also proposed to append a new section 194k in the Income Tax Act which states “Any person responsible for paying income arising from units of a mutual fund or a specified company must deduct tax at the rate of 10 percent of such income”, according to the Finance Bill 2020. It was later clarified that the TDS will be imposed on only the dividend pay-out over Rs. 5,000 per annum and no TDS shall be required to be deducted by the mutual fund on income which is in the nature of capital gain. This gives another reason for the investors to shift to the growth option and avoid the deduction of TDS from the profit.

Withdrawal of DDT will have a positive impact on the NAV on the fund as well. Since the companies have been exempted from paying DDT, this will increase the yield which in turn will have a better appreciation on the NAV of the mutual fund. Along with that we also believe that this change will bring more awareness amongst the investors. Most investors think that the dividend on a mutual fund is tax-free as they don’t understand the concept of DDT. Thus, their effective tax liability will come down now.     

We, at DreamLadder, always believed the growth option to be better because of the power of compounding. The dividend option in true sense is just like getting your money back, which is great if you are investing just for cash flow management. But with the power of compounding your yield can grow exponentially as the chances of spending are less in the growth plan. Now, with the withdrawal of DDT and also imposing TDS, we believe that the trend of shifting from the dividend plan to growth plan will accelerate as people will start seeing the upside of the growth plan.