The long-term capital gain tax is exempt in case the total gains made on the equity mutual fund investments are below Rs 100,000 in a financial year. For small investors, it makes sense to shift from dividend to growth option immediately.
Investment in mutual funds comes with an endless number of options. One of such options is the choice between a fund with a growth option and a fund with a dividend option. Growth option means that an investor in the fund will not receive any dividend. The holder allows the fund company to reinvest the money which increases the Net Asset Value of the mutual fund.
The dividend option is good for investors seeking to receive regular cash payouts from his/her investments. In a dividend reinvestment option, dividends that would otherwise be paid out to investors is used to purchase more shares in the fund. Instead of paying the cash to investors, administrators buy more funds with the cash on behalf of investors.
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A situation may arise wherein investors decide to swap the type of fund. Changing from dividend to growth option in a mutual fund amounts to the redemption of old units, which attracts tax. To shift to the growth option, the investments need to be redone. One distributor explained that the tax on the redemption as well as on dividend is the same, which is 10 per cent.
However, the dividend option is less tax efficient in the long run. The long-term capital gain tax is exempt in case the total gains made on the equity investments are below Rs 100,000 in a financial year. For small investors, it makes sense to shift from dividend to growth option immediately.
For example, suppose you had accumulated Rs 400,000 over the past five years in a balanced fund until March 31st, 2018. For computing the long-term capital gains, you had to take the fund value as on March 31st, 2018. For instance, if the fund grew by 10 per cent since then, if one chooses to redeem now, the gains made since March 31st, 2018 will be Rs 40,000.
Now, if you do not have any other capital equity gains, then the entire Rs 40,000 will be tax-free as it is below the exemption limit of Rs 100,000. But, if the fund declares Rs 40,000 as a dividend, then there will be a mandatory dividend distribution tax on it.
Investors can go for a systematic investment plan over the year. It is more tax efficient not only for equity investments but also in case of debt funds. The latter attracts a 28.33 per cent DDT. While in the equity funds, LTCG applies after a holding period of one year. In debt funds, withdrawal before three years is taxed as short-term capital gains (STCG). The gains are added to the income of the investor and taxed based on his income tax slab. If the tax slab of the investor is 20 per cent or lower, he will end up paying much higher tax if he opts for the dividend option in a debt fund.
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Dividend option works only for those who are in the highest tax bracket. It is ideal for someone who wants a cash flow from the first year of investment. To make withdrawal more tax-efficient, the best option is to start the SWP (Systematic Withdrawal Plan) after three years of investment. Systematic Withdrawal plan is scheduled investment withdrawal plan. One can customise the cash flow to either withdraw just the capital gains on the investment or a fixed amount. One has the flexibility to withdraw only the capital appreciation made on the investment amount. If you withdraw units from an SWP in less than 36 months then the withdrawn amount will be taxed as per your income slab. The long-term capital gain tax is 10 per cent without indexation and 20 per cent with indexation.