It is unfortunate that mutual fund dividends are among the least understood aspect of mutual funds. They are often used when unnecessary and without understanding tax implications. In this post, I discuss when mutual fund dividends make sense and when they do not.
The first step is to understand that a fund declares a dividend by actually selling some securities (stocks/bonds). So when the dividend is paid out, the NAV drops to the same extent. Read more: When do mutual funds declare dividends
The second misunderstood aspect is that there is no difference in volatility or returns between dividend option and growth options. A dividend should not be considered as a cash payment like a redemption. Regardless of what is done with it, for return calculations, it should be treated as reinvested. Read more: How to calculate returns from Dividend Mutual Funds?
When Mutual Fund Dividends Do Not Make Sense
- Dividends from non-equity mutual funds are taxed at the rate of 28.87% at source. So it makes no sense to buy the dividend option of any non-equity fund, especially monthly income plans: How and When to use Mutual Fund Monthly Income Plans
- Dividends from equity mutual funds are tax-free but is no practical use to those trying to build a corpus.
So this pretty much means equity fund dividends, can be of some use to retirees under certain conditions and if they know how to use it.
When Mutual Fund Dividends Make Sense
The idea of a fixed income after retirement from a pension plan (annuity), monthly income scheme, senior citizens savings schemes etc. is quite comforting. Unfortunately, they will be taxed as per slab.
If I belong to the 0% or the 10% slab and if my expenses are not as high as the pension, I can manage to not pay tax. Either because I don't have to, or I can get myself a tax-saving instrument (not easy post- 60, but let us not get into this now).
In this case, if I can spare some corpus to invest in an equity fund, I would rather choose growth than a dividend. So that the corpus can be useful when my expenses exceed the pension. Even if I prefer dividends, they will have to be reinvested in equity. Otherwise, I may not able to handle the effect of inflation. Of course, this can be calculated. I would recommend a simple tool like this: Four Simple Retirement Planning Tools.
Hang on. What does, "If I can spare some corpus" mean? There are situations in which a retiree does not have enough corpus (regardless of current tax slab) and cannot afford to take any risks. Then there is no corpus to "spare". This can be determined with a calculator published here: When should senior citizens purchase an annuity?
I would like to reiterate that the quality of financial advisory post-retirement is abysmal and retirees should think twice about investing in equity funds, balanced funds or arbitrage-oriented balanced after retirement just to get tax free dividend income without analysing their future needs.
So let us assume that I have some money to spare, then can I use dividend option?
Yes and No.
No, to dividend option from equity savings funds or arbitrage funds.
Yes, if some portion to allocated to growth option funds for use a decade or so later. The rest can be from say the monthly dividend option of balanced funds.
The monthly dividends can be a way to reduce risk associated with part of the equity corpus. Overdoing this can hurt keeping pace with inflation later on.
Of course, I am assuming that dividend will be used as extra income to be spent or reinvested upon market "dips". If the dividend is immediately or systematically reinvested into equity, they are of little use.
A dividend will not reduce the number of units held. But there are plans in which some units will be redeemed and paid out if the fund cannot declare a dividend. This is dangerous as it will reduce the capital. So watch out for those: Do not choose the moneyback feature of ICICI Balanced Advantage Fund!
If periodic dividends are not necessary, one can opt for the normal dividend plan. Here the fund manager will not book profits each month and will only do so if it is large enough.
Dividends makes perfect sense when I do not have any pension
Suppose I do not have any annuity. I can divide my retirement corpus into three buckets.
(1) fixed income: say PPF + debt mutual funds (enough for at least first 15 years)
(2) Equity Growth (enough to grow and last for next 15 years)
(3) Equity (monthly) Dividend
You can use this tool to allocate: Inflation-protected Income Simulator
If I receive a monthly dividend from the equity fund, then I manage expenses with just that or draw a little more debt funds (or PPF if necessary).
I will be taxed only when I withdraw from the debt fund. Unlike monthly income from deposits or annuity. And if I withdraw less (due to the tax-free equity dividend), then up to the tax-free limit of 2.5-3L, no tax has to be paid. Rest with indexation at 20%. This is a great way to reduce taxation in retirement. Defer taxes to power compounding!
So this makes a lot of sense at least for those in 20% or 30% slab in terms of expenses - Are you spending too much?! Here are simple ways to find out.
Very few people either fall in this category or have a large enough corpus to get such dividends.
It is important to understand that the principal is at risk in an equity fund. So the lure of tax-free dividends (not guaranteed) can be dangerous.
Of course, one can keep things simple and withdraw when needed from a growth plan too.
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