Mutual fund investors can benefit from a significant tax advantage on dividends received by schemes, as these dividends are not taxed at the scheme level. According to reports from Mint, the full amount can remain invested and compound, unlike direct stock dividends, which are taxed at the investor's slab rate. For an investor in the 30% tax slab with 4% cess, ₹1 lakh of dividend income translates into ₹31,200 in tax, with surcharge capped at 15% pushing the effective rate to around 36%.
If a mutual fund receives dividends from stocks it has invested in, these dividends are not taxed at the scheme level. As reported by Mint, neither the scheme nor the AMC pays tax on these dividends, and it does not affect the total expense ratio (TER). Nilesh D Naik, Head of Mutual Funds at PhonePe, explained that these dividends are reflected in the scheme's Net Asset Value (NAV), with investors subject to long-term or short-term capital gains tax depending on their holding period. The wealth effect comes later through reinvestment, with the cash being reinvested in full with no tax taken out.
For investors in higher tax brackets where the personal tax slab rate is 15% or higher, growth options of mutual funds may be more tax-efficient than the IDCW option. According to Mint reports, since mutual funds do not pay tax on dividends from underlying stocks, investors in higher tax brackets can benefit significantly. However, given that the average dividend yield in Indian equities is only 1% to 1.5%, the overall impact of this tax efficiency is limited.
From April 2021, SEBI renamed the dividend option in mutual funds to income distribution cum capital withdrawal (IDCW). As reported by Mint, both payout and reinvestment forms are taxed like stock dividends at the investor's slab rate. Sougata Basu, Founder and CEO of CashRich, noted that the reinvestment form is the worst option, as it is taxed as income then reinvested at fresh cost, with nothing gained and tax paid. For investors with total income below ₹12 lakh, direct dividends may be more tax-efficient as dividends are taxed as normal income while equity long-term capital gains are taxed at 12.5%.
