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Now, ignore the dividend option

Now, ignore the dividend option

With dividend distribution tax up to 25% starting June 2013, it makes sense to abandon the dividend option, in favour of the growth option coupled with systematic withdrawal plan.

The dividend option of debt funds was favoured by retail investors over fixed deposits (FDs) because of its tax efficiency. A dividend distribution tax (DDT) of just 12.5% easily beat the post-tax returns of an FD for those in the 20-30% tax brackets. With the DDT raised to 25% (plus 3% cess), however, the benefits of the dividend option are relatively meager for those in the highest tax bracket and completely eliminated for others. But don’t think of switching back to FDs just yet if you’ve been comfortable with the returns from your selection of debt funds. Here’s a great idea that ensures you get regular income from your investments while keeping your investments tax-efficient.

Withdraw your debt (growth) plan
If you’re an investor who wants regular income from his debt funds – whether liquid, ultra short-term, short-term, income, gilt or monthly income plans – consider the growth option. Sounds surprised? Worth the growth option, all gains are reinvested, so where will the money come from? We’re not done yet, of course.

What you need to do to make this work is set up a systematic withdrawal plan (SWP) a year after you make the investment. An SWP, as you may have guessed, is the exact opposite of the systematic investment plan (SIP). It can be quickly set up online and you may select the frequency of the payout – monthly, quarterly, half-yearly, or annually. Another benefit of this, particularly if you’re interested in regular income, is that you can select how much you want withdrawn each time. If you want Rs20,000 each quarter, this amount will be systematically debited from the corpus every quarter, while the remainder will continue to generate returns.

Why the growth option?
On analysing how the growth option is taxed, you’ll quickly realise its benefits. Let’s compare:

Dividend option: All dividends are taxed at 28.32%, no matter which tax slab you’re in, under DDT. This applies to investments held under a year and over a year.
Growth option: Returns are taxed at the slab rate if held for under a year and at 10% (without indexation) and 20% (with indexation), whichever is lower, if held over a year.

Verdict: With the increase in the DDT, the only person for whom the dividend option makes sense is one who falls in the 30% tax bracket, but wishes to withdraw his investment in under a year. Unless you fall into this category, opt for the growth option, then start an SWP, but only a year later so that returns are taxed at a lower rate, as in the following table.

Investment Fixed Deposit Mutual fund (Growth) Mutual fund (Dividend)
Rate of return 9% 9% 9%
Income tax rate 30.90% 10.3% NA
DDT NA NA 28.33%
Post tax yield 6.22% 8.07% 6.45%

Best of both worlds
The tax efficiency of the growth option coupled with the guaranteed flow of cash from your SWP would yield more tax-efficient returns. While this method will require you to go without regular income from these investments for the first year (as the growth option is only tax-efficient for investments held for longer than one year), the eventual benefits you would receive will make it more than worth the wait.

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