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I was reviewing the mutual fund portfolio of my client Arun. It was not surprising to see his  investments were only in debt funds (given his risk profile). What was surprising was that his returns were as low as 6% (compounded return over a 3 year period) when most of debt funds in the declining interest regime had given returns of around 9-10%.

I delved into the details of his funds and noted that he had opted for the dividend option in his funds (The returns he obtained was calculated taking dividends into account). I asked him why? He replied back “How do you expect me to meet my monthly expenses without this dividend? Anyway, this dividend is tax free for me so I can go for it. What is wrong with it?”

This is a problem most retired people face: How to meet their monthly expenses having most of their funds invested. Hence, the most common decision - Go for the dividend option. 

However, it is a myth that the dividend from debt funds is tax free.

Dividend Distribution tax (DDT)
When debt funds distribute dividend, they must first pay a DDT ( Dividend distribution Tax) of 28.84% to the government. Hence, if a debt fund has earned 10% income in a year & decides to pay the whole income as a dividend, a tax of 2.9% is first deducted and the residual 7.1% is paid as the dividend to the investor. Thus, the realized return for the investor is 7.1% only. No doubt this income of 7.1% is tax free in the hand of investor. In case of equity funds, this is not the case. The dividend that a mutual fund earns from company dividends are subject to DDT. The real income of equity funds comes from capital gains & in case of equity funds.both long term & short term capital gains are tax free.

The question now is, Is there a better way to meet the goal of monthly expenses while ensuring lower taxes and higher returns at the same time? 

Systematic Withdrawal Plan (SWP)
We suggested Arun to opt for SWP. The investor opts for a monthly withdrawal of a predefined amount as per his need. On each predefined date, the required number of units depending upon the NAV on that date are redeemed & funds transferred to the investors account. The difference between the original purchase price & the price redeemed is the income for the investor. Although this is slightly different from the dividend option, there are different tax implications for the investor particularly after 3-years of investing in the fund.

This is because for any unit redeemed after 3 years, the income is considered ‘Long Term Capital Gain’ and taxed in a different manner. In this case, the tax rate is 20% after indexation. We have explained this in our previous blog post here. We are also explaining the same below -

Tax Benefits
In pure layman terms, indexation is the benefit that the government provides to account for the increase in consumer price index (CPI) i.e. inflation over a period of time. An item that had a cost of Rs 100, 3 years back will not cost the same now. Its cost would have increased to say Rs 110 by now. Indexation takes this cost of Rs 110 into account for calculation of taxes rather than Rs

100. Simply put, if you have earned an income of Rs. 30 over a period of 3 years on an initial investment of Rs. 100. Your ‘true income’ for the purpose of tax is Rs. 30 – Rs. 10, i.e. Rs. 20, which is a way of compensating investors for inflation.

Indexation is calculated with the help of the Cost Inflation Index (CII) that is released by the Income Tax department annually and you can get its statistics from 1981. Let us now calculate taxes for debt mutual funds assuming the investment year to be 2010 (I shall take actual numbers of CII so that you are clear with the taxation applicable).

As the below figure shows, the tax paid by the investor is significantly lower. It should be noted tlhat in case funds are withdrawn before the initial 3 year period, there is no income tax benefit and you shall be charged at the marginal rate.

Given the above, it is better to opt for SWP option for meeting your monthly expenses rather than the dividend option.

Please feel free to contact me at fin.chikitsak@gmail.com for any queries or if you have any questions.

Happy Investing!