Should I stop buying dividend stocks since dividends are now taxable?

Published: September 4, 2020 at 11:10 am

As per Finance Bill FY 2020-2021, a person who receives dividend income from stocks and mutual funds must add it to total income and pay tax as per slab. Does this mean investors should stop buying dividend stocks since a portion of it would be lost to tax?

Investors must first understand that this is not a new tax. Dividends from domestic companies were taxed at source at the rate of 20.35% up to March 31st 2020.  This rate includes the surcharge of 12% and cess of 3% on the base rate of  15%. This dividend distribution tax (DDT) has been removed. This means the actual quantum of dividend in the hands of the investors would increase (although there is no way to quantify this) but tax as per slab has to be paid on this.

If we superficially look at this only from the taxation point of view, then those whose income is below the taxable limit (including dividends) will gain the most from DDT removal – but then again, their dividend income is unlikely to be significant.

Those in the 5% slab would only pay 5.2% tax on dividends; those in the 20% slab would pay 20.8% tax on dividends and those in the 30% slab would pay 31.2% tax on dividends after including cess.

Thus the change in dividend taxation is unlikely to affect the majority of stocks investors. Yes, those with significant dividend income will now have to shell out almost 11% extra tax from this financial year.  Thus the question of whether or not to stop accumulating dividend stocks applies only to them.

Many young investors have incorrect impressions about stock dividends. They believe a growth stock is better than a dividend stock. While it is true that dividend income is best reinvested when we are building a corpus, it is certainly not undesirable.

Say you are a private equity investor. You put in Rs. 1 lakh and after a couple of years, the company has seen its first profit. The board wants to decide how much of the profit should be reinvested and how much distributed as income. What would you vote?

Would you blindly vote for 100% reinvestment in the hope of higher future gains or would you like to realise part of the profit now and lock away that gain? Since you do not run the company yourself, it would be hard to bet on future growth that is dependent on a myriad of know and unknown factors. Some immediate profit for your investment is always prudent.

Stocks dividends work on the same logic. Dividends are a fantastic way to remove investment risk. A regular dividend-paying company may not always be sought after in the market.

For example, if you look at the share price of ITC over the last 5 years, it has moved nowhere but 12.6% of the purchase price was paid out as a dividend during this time. During the same period, HUL price has moved up 156.6% and this excludes the 12.8% paid out as dividends (over 5Y).

If we increase the lookback period the dividends are even more fantastic but that is not the point. There is some hindsight bias here, but both HUL and ITC were “good companies” five years ago too. So this not at the same level as “if you had purchased Wipro as an IPO …”

A regular dividend-paying stock is worth its weight in gold for anyone trying to build a source of income because it regularly removes risk from the table. Naturally, this would take years and years of gradual accumulation.

If you already hold a sizeable chunk of dividend stocks, there is no reason for you to stop accumulating or sell these just because you will have to pay a little extra tax. Even after the almost 11% additional tax payout (for those in 30% slab), the risk reduction and the natural benefit of a regular income source is significant.

A good chunk of such stocks can be part of the retirement portfolio basket. Naturally, you cannot depend on this income for regular monthly expenses, but the next time a gadget fails (how else will that company profit!), a dividend income might allow you to buy a better replacement well into retirement.

This logic does not apply to mutual funds. If you are receiving “income” via the dividend option of, say a balanced advantage fund then immediately switch to the growth option. When you redeem you can exploit the Rs. one lakh tax-free limit for LTCG.

Yes, this LTCG rule applies to stocks as well, but the risk is significantly higher. Of course, when you are building a corpus and do not want regular income, this risk is more than acceptable. However, when you want to use stocks as an income source then regular dividend payouts are any day better than “growth” governed by market forces.  As always the context depends on your need. Sometimes a change in tax rules necessitates a change in investment strategy and sometimes not. 

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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