“Dividends are unethical. They give you the impression that you are getting something extra from the fund. However, you are not. The dividend is just your returns being given back to you.” – Parag Parikh, in the first unitholder meet held in Chennai and Mumbai, Nov 2014. Sources: this author, who attended the Chennai meet as an NFO investor in the fund; a Moneylife article covering the meet, also reproduced by the fund house.
So, you can imagine our surprise when PPFAS announced the introduction of the Income Distribution cum Capital Withdrawal (IDCW) Option in their flexicap fund.
IDCW is the accurate, yet unappealing, name given to the dividend option by SEBI. We shall continue to refer to the IDCW option as the dividend option, as it rolls off the tongue more easily.
This change in fund attribute does not affect growth option investors.
Why introduce it now? The AMC would not have introduced it unless it saw an opportunity to build AUM. For some investors, dividend income from an equity fund may be more favourable (tax-wise, not risk-wise) than long term capital gains. However, even then, the equity exposure, particularly with this fund offering a dividend option, would still be relatively small.
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This favourable tax treatment is only available to those in the lower tax brackets. But therein lies the problem. People are in the lower slabs because of a lower net worth. In other words, they do not have sufficient funds to handle significant market risks. So this benefit is largely theoretical unless one buys in the hope of “regular” dividends (neither the quantum nor the frequency of dividends is guaranteed).
Times change, management changes, and that’s just the way it is. One can only hope that the dividend option is not misbought or mis-sold to those who can ill-afford to take on market risks.
Now, consider some unrealistic situations where the total income is either from dividends or only from equity LTCG. Equity LTCG refers to Long Term Capital Gains (Charged to tax @ 12.5%-Covered u/s 112A. The first 1.25L is tax free)
Case 1:
- 5.52L Dividends. Tax = zero.
- 5.25L Equity Long Term Capital Gains. Tax = zero.
Case 2:
- 12L Dividends. Tax = zero. ✅
- 12L Equity Long Term Capital Gains. Tax = Rs. 87,750
Case 3:
- 15L Dividends. Tax = Rs. 1,09,200 ✅
- 15L Equity Long Term Capital Gains. Tax = Rs. 1,26,750
Case 4:
- 17L Dividends. Tax = Rs. 1,45,600 ✅
- 17L Equity Long Term Capital Gains. Tax = Rs. 1,52,750
Case 5:
- 17.95L Dividends. Tax = Rs. 165,360
- 17.95L Equity Long Term Capital Gains. Tax = Rs 165,100 ✅
- The crossover is around here.
Case 6:
- 20L Dividends. Tax = 2,08,000.
- 20L Equity Long Term Capital Gains. Tax = Rs. 1,91,750 ✅
Case 7:
- 24L Dividends. Tax = 3,12,000.
- 24L Equity Long Term Capital Gains. Tax = Rs. 2,43,750 ✅
We reiterate that this is only math and does not represent reality.
Let us consider some alternatives.
Case (a) A person wants Rs. 10 lakh in the FY for expenses.
- If the entire income comes from dividends and interest (in any proportion), the tax payable is zero. ✅
- If 50% comes from interest income and 50% from equity LTCG, the tax payable is Rs. 48,750
Case (b) A person wants Rs. 15 lakh in the FY for expenses.
- If the entire income comes from dividends and interest (in any proportion), the tax payable is Rs. 1,09,200
- If 50% comes from interest income and 50% from equity LTCG, the tax payable is Rs. 81,250
- If 2/3rd comes from interest income and 1/3rd from equity LTCG, the tax payable is Rs. 48,750 ✅
Case (c) A person wants Rs. 20 lakh in the FY for expenses.
- If the entire income comes from dividends and interest (in any proportion), the tax payable is Rs. 2,08,000.
- If 50% comes from interest income and 50% from equity LTCG, the tax payable is Rs. 1,13,750 ✅
But then again, are these realistic? For most investors, the equity allocation in their portfolios when they wish to receive income will be a small portion (thankfully, it should be that way since most people will have high withdrawal rates and cannot afford to take on too much capital market risk). So the dividend option, if any, would be, well, should be small.
The dividend option is unreliable. They are not guaranteed (the same applies to capital gains). So, equity growth or dividend option should not be relied upon for immediate income before or after retirement.
At best, dividends from equity can be used for discretionary spending; however, we might as well redeem and pay the LTCG tax when we need the money.
The dividend option is only marginally useful for a small section of retail investors (who should not depend on it anyway).
Whether it comes from PPFAS or any other fund house, our recommendation remains the same. Avoid the dividend (IDCW) option and stick to growth. If you want income from mutual funds, use short-term debt funds like liquid funds and money market funds. Those with a higher net worth and higher risk awareness can consider arbitrage funds and other debt categories.
Dividends or CG from debt funds are taxed as per the slab (so choose growth!). Use an equity fund (direct plan, growth option) for growth if your withdrawal rate is high enough. Please keep it simple. Fund houses may change policy, but basic personal finance advice never changes.
Related read: Do not get emotionally attached to your mutual fund investments!
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