If you are using the dividend reinvestment option in your mutual funds, chances are you are confused about the implications of taxes in the new LTCG regime. At least one person is. Let’s clear the air.
Here are 3 questions posed by a reader about taxes on dividend reinvestment.
- Is the dividend reinvest being taxed. If yes, at what rate?
- The gains realised in this option, whether they are part of the exemption limit of 1 lakh or will it be over and above this?
- Finally… with new rule on MF/ EQUITY being taxed even after one year should we now change the holding from Dividend Reinvest to GROWTH?
Here’s my response:
LTCG tax is applicable on long term capital gains. If you sell your equity MF or direct stocks after 1 year of holding, then upto Rs. 1 lakh of LTCG is exempt.
On all gains above Rs. 1 lakh, you have to pay LTCG tax at 10%+surcharge. This has to be paid by you.
In case of dividend option, when the dividend is paid out or reinvested, the MF collects 10%+surcharge as dividend distribution tax (DDT) from your money and pays out to the government. The remaining amount is paid out to you.
[UPDATE: The DDT has been abolished in the year 2020. Dividends from mutual funds and stocks are now taxable in the hands of the investor.]
You have to pay no further tax. The 1 lakh exemption limit is not applicable here on the dividend that you received.
However, when you sell your fund with the dividend reinvestment option, any gains that you realise there due to selling, are subject to the same LTCG tax conditions.
Let’s take an example.
Suppose you invested Rs. 1 lakh in ABC fund – dividend reinvest option. Over the next 1 year, your investment in the fund grows to Rs. 1,10,000 in value.
The fund then declares Rs. 2000 as dividend for the number of units you hold. However, there is a dividend distribution tax payable now. The net that will accrue to you is Rs. 2000 – Dividend distribution tax at 10%, that is, Rs. 1800* approx. This Rs. 1800 is reinvested.
Your purchase value is Rs. 1,00,000 (original investment) + Rs. 1800 (dividend reinvested). Total Rs. 1,01,800.
After another 6 months, say you wish to sell the units acquired from your original investment of Rs. 1 lakhs. The value of those units is now Rs. 1,08,000.
When you sell, you realise Rs. 8,000 of long term capital gains. (Rs. 1,08,000 – Rs. 1,00,000). Assuming, you don’t have any other long term capital gains from equity or mutual funds, this Rs. 8,000 will be exempt from taxes. (It is less than Rs. 1 lakh)
However, if your investment was much higher, say 20 times of Rs. 1,00,000, then the situation will be different. Your gain now becomes Rs. 1,60,000 (8000 * 20).
Of this, Rs. 1 lakh is exempt. On the remaining Rs. 60,000, you have to pay tax at 10%, that is, Rs. 6000.
*Surcharge ignored for now.
Hopefully, this is clear now.
So, what should you do?
This is for the 3rd question posed by the reader.
Now, if you are interested in making your money compound over long term without any interruption of taxes, growth option is the best one to go for.
The 2 downsides of dividend reinvestment option
#1 As you realise, in case of dividend reinvest, there is a forced taxation whenever a dividend is declared. You also get no benefit of the Rs. 1 lakh exemption on the long term capital gains.
#2 Remember that the new units acquired through dividend reinvestment will have a fresh period of exit load and calculation of 1 year for capital gains.
When you choose dividend reinvestment option with your equity mutual funds, your investing behaviour fails you.
Do you use the dividend reinvestment option with equity funds? What’s your reasoning? Do share in the comments.