The Hindu Business Line : Fund Talk

What does the Budget proposal to hike dividend distribution tax on liquid/money market mutual funds mean for individual investors? Should they switch into other investment options?

Present position: Liquid/money market funds, which invest in very short-term debt instruments, are usually ideal as a parking ground for temporary surpluses, as they allow you to withdraw investments at any time. These funds have been delivering annualised returns of about 6.5-7 per cent in recent months, due to tight liquidity conditions and the series of rate hikes by the RBI. These funds usually offer both dividend and growth plans. If your investment horizon is less than a year, the dividend plan currently offers the more tax-efficient mode to earn your returns. This is because returns earned by way of dividends from debt funds are subject to a flat rate of Dividend Distribution Tax (DDT), at 14.3 per cent (including surcharge/cess). Returns earned from the growth option within a year of investment are treated as short-term capital gains and taxed at the marginal tax rate (based on your tax slab and going up to 30 per cent). Returns from the growth option, if you hold units for more than a year, are treated as long-term capital gains and taxed at 20 per cent, if you get the benefits of indexation, or at 10 per cent, if you don't.

The changes: With effect from April 1, the Budget proposes to increase the rate of DDT from 14.3 per cent to an effective 28.32 per cent (inclusive of surcharge/cess) for liquid/money market funds. No other changes are proposed; but because of the increase in education cess, your rate of short-term capital gains tax will climb to 33.9 per cent if you are in the 30 per cent bracket and 23.6 per cent, if you are in the 20 per cent bracket.

What you should do: Switching entirely out of liquid/money market funds does not appear prudent, as they still offer higher liquidity with superior returns when compared to savings or even term-deposit options from banks, for short tenures.

If you are in the 20 per cent tax bracket, switch from the Dividend to the Growth option, as your returns will then be treated as short- term capital gains. Your effective tax rate will stand reduced to 23.6 per cent of your returns, against the 28.3 per cent proposed to be levied on dividends.

If you are in the 30 per cent tax bracket, staying with the Dividend option appears the right course of action because for you, the effective tax rate on dividends (at 28.3 per cent) would still be lower than that on short- term capital gains (33.9 per cent).

If you plan to stay invested for over a year, the Growth option appears the better alternative, as the effective tax rate on your returns will be the long-term capital gains tax rate of 20 per cent with indexation benefits.

For investors who have a nil tax incidence, the Growth option remains the more tax efficient option across horizons, because in the Dividend option, you would suffer incidence of DDT irrespective of your tax status.

Finally, investors who can lock in their investments for shorter tenors, such as three to six months, should actively supplement their liquid fund investments with fixed maturity plans (FMPs), as the latter offer superior yields and may not be subject to higher rates of DDT (based on the current interpretation of the Budget proposals). Do keep an eye out for short-term FMPs rolled out by fund houses from time to time.

Queries may be e-mailed to mf@thehindu.co.in, or sent by post to Business Line, 859- 860, Anna Salai, Chennai 600002.

Aarati Krishnan

More Stories on : Mutual Funds | Dividend Announcement | Income Tax

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