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Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

If you are an equity investor, you would have experienced the pleasure of receiving dividends from the company whose stock you have invested in. Receiving dividends feels good; you get additional cash to spend. However, smart investors who want to build wealth within a shorter period of time would prefer not receiving dividends; instead, they would want the dividends due to them to remain in the company and reflect in the share price (the price would be higher to the extent of dividends due to the investor).

While companies do not offer this facility, fortunately, mutual funds do. In fact, mutual funds offer dividend retention in two forms:

1. Dividend reinvestment/transfer

2. Growth

However, if you do want dividends and need the money to meet expenses, you can select the ‘dividend payout’ option.

Let’s understand these options in detail.

About dividend payout (usually referred as dividend):

In the ‘dividend payout’ option, dividends are declared and paid out to you. This option is suitable for investors who need regular income from their mutual funds. While you may receive income in the form of dividends regularly, you lose out on the opportunity to reinvest and grow your investments.

About growth:

In the growth option, no dividends are declared. The dividends remain invested in the fund; this is reflected in a rise in the NAV of the fund. In this case, the number of units you hold remains the same. This strategy is suitable for investors who want to benefit from long-term appreciation of wealth particularly through equity investing as all profits that the fund makes are reinvested into the fund. However it is important to note that the long-term capital gains for equity funds is taxable at 10% for capital gains exceeding one lakh for a financial year, as proposed by Finance Bill, 2018

About dividend reinvestment:

In the ‘dividend reinvestment’ option, dividends are declared but not paid out to you. Instead they are reinvested at the NAV of the fund after dividend declaration. This results in you receiving more units in the fund and increases your investment capital in that fund.

Dividend reinvestment in case of equity funds:

Conceptually, dividend reinvestment option is like growth option for all equity funds. However, be aware that while growth option units will enjoy long-term capital gains tax benefits after one year of investment, re-invested units must be held for one year from date of re-investment to qualify for long term capital gains tax benefits. Also, it should be noted that for investment in ELSS funds, reinvested units will be subject to three-year lock-in. Further, as proposed by Finance Bill, 2018, in case of equity funds, dividends declared shall attract dividend distribution tax at the rate of 11.648%.

Dividend reinvestment in case of debt funds:

In case of debt funds, dividends declared attract dividend distribution tax at the rate of 29.12%; you receive credit of dividend after the mutual fund pays this tax. Also reinvested dividends need to be held on for 3 years to be eligible for long term capital gains tax benefits (benefit of indexation and a lower tax rate of 20%). (FYI, the DDT rate has undergone a change due to introduction of 4% health and education cess instead of 3% education cess)

Dividend reinvestment versus growth:

It is extremely important to understand the difference between dividend reinvestment and growth. Let’s study the table below to get a better understanding:

Note: The NAV numbers are merely hypothetical

The tax impact:

When you redeem/sell your mutual fund units and earn a capital gain, your choice of dividend reinvestment or growth will affect the amount of tax payable on the gain. It will vary between equity-oriented funds (where the equity investment is more than 65% of the fund’s portfolio) and non equity oriented funds (where the equity investment is not more than 65% of the fund’s portfolio).

In case of equity-oriented funds:

*Plus applicable surcharge and health and education cess

In case of non equity-oriented funds:

^plus applicable surcharge and health and education cess.

Tax levied on any income results in lower wealth accumulation to that extent.For those investors who don’t need the liquidity of dividends, the facility of dividend reinvestment or growth becomes useful for quicker wealth accumulation.

About dividend transfer:

Dividend transfer is a type of scheme that can give investors the benefits of both debt and equity investments.

The source scheme is usually a debt fund and the target scheme is usually an equity fund; the dividend declared in the source scheme is invested in the target scheme. This scheme is suitable for investors who would prefer a lower risk option to of their investments or principle, while getting some benefits of growth from equity investments as well.

Here is a quick snapshot of all the options:

Note: The tax structure/benefits are as per the current Income Tax Act, 1961 and may change in the future