Dividend Mutual Funds – Definition & Tax Implications

Mutual Fund Investors sometimes prefer an income in the form of dividends from their investments to cater to some inevitable expenses. This is when they opt for a dividend mutual fund. In this article, we will explore dividend mutual funds in detail.

What are dividend mutual funds?

A dividend mutual fund primarily invests in companies that pay dividends. These dividends are mostly profits that the companies share with stockholders/shareholders. The profits are earned by selling the stocks at a price higher than the price they were purchased. The asset management company (AMC) adds these profits to the Net Asset Value (NAV).
On the other hand, AMCs cannot consider unrealized profits (when the profit is still on paper) from the instruments for paying dividends. However, sometimes they declare some part of unrealized gains as dividends. This decision is up to the fund manager. The asset manager also has the option to send the money back to buy stocks or debt instruments as per the scheme.

When are dividends paid to investors?

The Asset Management Company can choose to pay dividends on a daily, monthly, quarterly or annual basis. This generally varies from one scheme to another. Even though most dividend mutual funds strive to pay dividends and stick to their respective mandate, it is never guaranteed. The dividend amount is never fixed. An investor must also understand that under the dividend option, the Net Asset Value is not allowed to grow higher than a specified value. Once the NAV reaches its critical value, the fund house pays out the dividends.

What are the tax implications of dividends?

Dividends obtained from a mutual fund was tax-free for investors until 31 March 2020 (FY 2019-20). That was because the company declaring such dividend already paid dividend distribution tax (DDT) before making payment. However, the Finance Act, 2020 changed the method of dividend taxation. Henceforth, all dividend received on or after 1 April 2020 is taxable in the hands of the investor. The DDT liability on mutual funds stands withdrawn.
The Finance Act, 2020 also imposes a TDS on dividend distribution by mutual funds on or after 1 April 2020. The standard rate of TDS is 10% on dividend income paid in excess of Rs 5,000 from a company or mutual fund. However, as a COVID-19 relief measure, the government reduced the TDS rate to 7.5% for distribution from 14 May 2020 until 31 March 2021.
For instance, Mr Prashant received dividend amounting to Rs 7,000 from an Indian company on 15 June 2020. Since his dividend income exceeds Rs 5,000, the company will deduct a TDS @7.5% on the dividend income which is Rs 525. Mr Prashant will receive the balance amount of Rs 6,475. Further, the dividend income is the taxable income of Mr Prashant taxed at the slab rates applicable for FY 2020-21 (AY 2021-22).
Investors can opt for growth or dividend option based on their investment goals. So, people who wish to grow wealth over the long term, usually opt for growth option – this is because the compounding benefit is lost when the AMC pays you dividends.