Dividends – Meaning, Advantages & Tax Implications

Dividend, in financial terms, means a certain amount shared with shareholders of a company or a mutual fund on a regular basis – monthly, quarterly or annually. This money is either a portion of the profit made during that time period or taken from the company reserves as per the agreement between shareholders and company. The trend of giving out dividends seem to be on the rise with more and more AMCs adopting this option. In this article, we will cover all about dividends through the following topics.

Latest Update

In Budget 2020, the Finance Minister abolished the Dividend Distribution Tax (DDT). Now the incidence of dividend income taxation is shifted to investors from the companies.

Update from budget 2021:

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

Dividend

Dividend is like a bonus or reward a company or fund house doles out to its shareholders or investors. It can be given in the form of liquid cash or benefits or even stocks. Let’s not confuse dividends with interest or income. Dividend is a gesture of goodwill and it is up to the company or AMC to share a portion of the profit with its unitholders. Hence, there is no guarantee that they will continue to pay out. So, if the company is not doing well, don’t expect them to pay dividends out of their reserves. Interest and income from investments, on the other hand, are paid regularly whether the company makes profit or not.

How investors earn dividends

One reason why dividend option do not hold much favour is because the dividends make a dent in the net asset value of the fund. This is why it is often considered equivalent to unit redemptions. For instance, if you own 100 shares with an NAV of Rs. 10 – and the dividend announced is Rs. 1 per unit, which is taken from the NAV. This will bring down the NAV value from Rs. 10 to Rs. 9. In this example, your dividend will Rs. 100. But the value of the mutual fund units drops to Rs. 900 from Rs. 1000.

Dividends in mutual funds

Many mutual funds generally give their investors two options – growth option or dividend option. It is important for you as an investor to understand that a steady dividend from a company is not the same as dividends from mutual funds. While the former reflects the profitable running of the company, the latter doesn’t benefit the investors in the same way. Let us see how.

Considering that distribution of dividends doesn’t fetch any additional gain to the investor, financial experts often encourage people to go for growth option, especially if they have a longer investment horizon and long-term financial goals. If this is so, you might be wondering why the need of a dividend. The main reason is that it encourages people with low-risk appetite and short-term goals to invest. This also brings down the risks associated with equity funds as profits are distributed regularly.

Tax implications

Tax implication of dividend prior to FY 2020-21 is as below:

From FY 2020-21 onwards, the burden of paying tax on dividends is shifted on shareholders. The dividend distribution tax payable by the Indian companies is abolished.

The dividend income received by the shareholder for shares held for investment purposes is taxable under the head ‘Income from other Sources’. The taxpayer is allowed to claim interest expense up to the extent of 20 per cent of the total dividend income.

The companies shall deduct tax at source (TDS) at 10 per cent if the aggregate amount of dividend to the shareholder exceeds Rs 5,000 during the financial year.

Disadvantages of opting for dividend

Dividend plan vs growth plan is a debate as old as mutual fund itself and it is not expected to stop anytime soon. As mentioned above, it all depends on what you want out of your investment and your risk profile. So, if the dividend plan doesn’t address your investment goals, it can be disadvantageous as mentioned below.

In growth option, the tax rate ranges from 0 to 15% based on your tax slab rate and existing laws. For instance, if the capital gains is below 1 lakh, LTCG tax will be zero. However, in dividend option, tax on dividend is mandatory. You may choose dividends to receive steady cash flow.

But what if you do not require this money at the time?

Then the investment value is being compromised, aside from paying taxes on dividends. If you are confused whether to opt for growth plan or dividend plan, Cleartax can help you. Using our online calculators and other tools, you can assess your risk profile and investment horizon on our portal. Indeed, investing with Cleartax Invest is a quick and result-oriented way to invest in mutual funds.