Dividend Mutual Funds – Definition & Tax Implications

Taxpayers need to pay advance tax on dividend income only after the declaration or payment of a dividend has been made.

Some mutual fund investors prefer an income in the form of dividends at regular interval, and they can opt for a dividend mutual fund. However, the payment of dividends is not guaranteed in mutual funds.

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). However, AMCs cannot consider unrealized profits (when the profit is still on paper) from the instruments for paying dividends. Sometimes, they declare a part of unrealized gains as dividends, and this decision bestows with 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 (AMC) 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 in the hands of investors until 31 March 2020 (FY 2019-20). That was because the company declaring dividends paid dividend distribution tax (DDT) before making the dividend payment. However, the Finance Act, 2020 changed the method of dividend taxation. 

All dividends received on or after 1 April 2020 will be taxable in the hands of the investors as the DDT on dividends was withdrawn.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 Vinay received a 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 Vinay will receive the balance amount of Rs 6,475. Further, the dividend income is a taxable income of Mr Vinay, which is taxed at the slab rates applicable for FY 2020-21 (AY 2021-22). The Finance Act, 2020 also provides for the deduction of interest expense incurred against the dividend. The deduction should not exceed 20% of the dividend income received. 

However, you are not entitled to claim a deduction for any other expenditure incurred for earning the dividend income. In the above example, if Mr Vinay borrowed money to invest in units of a mutual fund and paid interest of Rs 3,000 during FY 2020-21, only Rs 1,400 is allowable as an interest deduction. 

Submission of Form 15G/15H: A resident individual receiving dividends whose estimated annual income is below the exemption limit can submit form 15G to the company or mutual fund paying the dividend. 

Similarly, a senior citizen whose estimated annual tax payable is nil can submit Form 15H to the company paying the dividend. The mutual fund informs the shareholder about the dividend declaration on their registered mail id and requires submission of form 15G or form 15H to claim dividend income without TDS. Investors can opt for the growth or dividend option based on their investment goals. So, people who wish to grow wealth over the long term, usually opt for the growth option – this is because the compounding benefit is lost when AMC pays you dividends.

ClearTax Invest presents you with both variants, hand-picked from the top AMCs in India. Start investing.

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