Thursday, February 1, 2018

Dividend Reinvestment could be the new preferred route instead of Growth Funds

Union Budget 2018-19 has introduced long term capital gain (LTCG) tax of 10% without indexation benefits on listed equity share bilding and equity mutual funds. There had been such a speculation of inclusion this tax from last year. Last year this tax was not introduced. LTCG is not new, it was there till first half of last decade. LTCG was scrapped 14 years ago and Security Transaction Tax (STT) was introduced in place of it. But this year government has re-introduced long term capital gains tax on equity.

Government has argued through this budget that with introduction of LTCG they are bringing tax parity between various financial instruments.

It is certain that long term capital gain tax on equity is likely to stay for long. 10% of LTCG tax on an investment portfolio nurtured for years will be a matter of concern. Equity investments have given phenomenal returns in past few years. According to finance minister Mr. Jaitely; investment into equities provided a tax free income for companies to park their surpluses into share market. Profit able businesses instead of reinvesting this money into their business rather choosed option of share purchase and hold for one year or more. Such action has major contribution towards prevailing buoyancy in the market. This money could have been used to lift economy further and job creation.

From macro economic perspective this is a welcome move. More jobs will be created. India's consumption story will benefit immensly from this. And hence returns from equity mutual funds may appreciate many folds for small investors like us.

A small investor will have a cushion on one lakh rupees of profit from equity, which will remain tax free. As per current law, dividend payout is tax free upto rupees 10 lakhs in a calandar year. So we have a refuge in form of dividend options provided by mutual funds. If you prefer a passive income or cash flow dividend payouts will remain tax free upto rupees 10 lakhs. However, FY2019 onwards equity mutual funds will also have the burden of dividend distribution tax (DDT). Till current financial year equity mutual funds were exempt from DDT.

If you are a fan of growth option in mutual funds by virtue of their enhanced compounding in long term, you can opt for dividend reinvestment option. With dividend reinvestment you can reduce your tax liability significantly

1. Dividend payout reduces NAV of mutual funds
2. Reinvestment option purchases more units on the reduced NAV
3. Net appreciation of NAV will be less compared to growth option of the same mutual fund. Fund folio will have increase in number of units hold not NAV. Hence, 10% tax liability calculation will be far less
4. Dividend payouts are still tax free upto 10 lakhs in a calandar year. So will be its reinvestment.
5. Above tax deferment will be at cost of DDT paid by Mutual Fund AMCs to government before distributing dividend. Subscriber will need not pay any tax for DDT. They will receive dividends post deduction of distribution tax.

Considering above facts, Mutual Fund AMCs will tweak their product design and policy accordingly to suit small investor interests.

Comments and further discussion are welcome

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