How tax (DDT) affects mutual fund dividends and lowers return (examples)

We are aware that debt mutual funds are subject to a dividend distribution tax (DDT). From April 1st 2018, equity mutual funds will also be subject to DDT. Here some examples as to how DDT affects mutual fund dividends and lowers returns.  This post is in response to Ankit Jain’s comment in Equity Mutual Fund Dividends are taxed 12.942% (not 10%): Here is how to avoid this.

What is dividend distribution tax and how does it work?

In simple terms, DDT is a tax deducted at source by a mutual fund house before the distribution of the dividend. After this, no further tax need be paid by the investor. Once the dividend is declared and DDT deducted the NAV of the debt mutual fund will fall to a proportional extent.

First, let us consider examples with debt mutual funds.

Up to March 31st 2018, debt fund dividends will be subject to 25% tax + 12% surcharge and 3% cess. After 1st April, the cess will be increased to 4%.

That is  25%*(1+12%)*(1+3%) = 28.84%. This is tax levied on the “grossed up dividend”

Suppose Rs. 10 is dividend received, the DDT is calculated as follows.

The grossed up dividend 10/(1-25%). And from this 28.84% tax is levied.

[10/(1-25%)]*28.84% =3.8453.

Thus the DDT amount divided by the divided received = 0.38453 or 38.453%.

In other words, 38.453% of the dividend received goes to the DDT. More examples can be found in the previous post. This gave many people (including myself) the wrong impression that for those in 30% tax slab, growth option is superior to dividend option – a fact that Ankit Jain pointed out is wrong.

Example 1: Daily dividend liquid fund.

This is an example of Mahindra Liquid fund Growth vs daily dividend (chose this because it the youngest and therefore only the latest DDT law would apply).

Growth vs Daily Dividend fund

Please ignore the spikes in NAV. They are probably momentary market value fluctuations or just database errors. Notice that the daily dividend reduces the NAV to its base value. This means, I can put one crore (if I had it) in the daily dividend plan and the capital gain would be zero. The dividend would suffer a DDT, but I have to pay no further tax. At least for less than 3Y, this is better than growth for those in 30% slab (this is Ankit’s point).

On July 4th 2016, both the growth and daily dividend plan had a NAV of Rs. 1000.1594  per unit.

On the 5th July,

Growth NAV = 1000.3231

Daily Div NAV = 1000.1594

The difference: 0.1637. However, the dividend distributed was only 0.118191 per unit. The rest is the dividend distribution tax.

The DDT = 0.0455 per unit ~ 38.5% of the total dividend distributed.

The fund house will declare NAV for the dividend option after deducting the dividend and DDT.

Now, suppose we add back the dividend and DDT to the NAV, we get:

Note, this is not a simple addition and the NAV growth bet dividends will have to taken into account.

As expected, it would be pretty much identical to the growth NAV, aside from rounding off errors.

Since the DDT is removed, the impact of this can be seen by reinvesting the dividend received alone.

effect of dividend distribution tax on mutual fund dividends

After 1Y from 4th of July 2017, the annualized return of the growth plan = 7.075%.

The annualized return of div plan with dividend reinvested = 5.088%. In other words, the return is reduced by 28.085% due to DDT. Hence suitable for those in 30% slab. The exact quantum of return reduction will depend on market movement, but will be lower than 31.2% (with 4% cess).

Example 2: Monthly dividend arbitrage fund with and without DDT

I have done the following calculation with Principal arbitrage fund. Top panel is without DDT (valid up to March 31st 2018) and bottom panel with DDT.

If a DDT = 12.942% of dividend received is deducted, the return is lower by about 9.85%.

I thank Ankit Jain and Krishnakumar Chandrasekaran for their inputs and Mahek Shah and Nimesh Samai (along with Ankit) for sharing their dividend fund transactions so that I could learn from it.

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6 thoughts on “How tax (DDT) affects mutual fund dividends and lowers return (examples)

  1. “This gave many people (including myself) the wrong impression that for those in 30% tax slab, growth option is superior to dividend option – a fact that Ankit Jain pointed out is wrong.”

    I’m confused. Should I opt for the Dividend option of an Equity MF, as opposed to the Growth option if I’m in the 30% slab?

    1. If you need is less than 3Y, choose div reinvestment for a bit lower tax (not much). Else choose growth.

  2. Some of these things are very difficult to plan.
    The dividend plan is better for 30%slab (marginally and only for debt funds) as long as we are sure that we will redeem before 3 years. But the moment it crosses the 3 years growth plan is significantly better.
    Also (unrelated to the topic) – for people in 5% slab short term gains are beneficial than long term for debt funds (depends on indexation declared too but in general) so it makes sense for them to not let the gains become long term.

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