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Should higher DDT on debt funds worry you? - Outside View by PersonalFN

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Should higher DDT on debt funds worry you?
Mar 21, 2013

Faced with intractable fiscal deficit situation, Finance Minister, in Union Budget 2013-14, has tried to pull out all the stops to bolster up revenue by plugging loopholes in taxation. However, this has resulted in some of most popular investments avenues losing their appeal. Debt oriented funds could be an apt example. Let's assess how new tax provisions are going to affect functioning of these funds and how would it affect your investments.

What has changed for debt oriented funds?

Debt oriented funds offered by fund houses have become quite popular these days with investor. Ain't you putting more in debt funds today than what you used to be a few years back? Thanks to falling interest rates and growing awareness about debt mutual funds. Interest rates and bonds prices share inverse relationship. A debt fund gains when bond prices go up. Recognising the popularity of debt oriented funds, budget 2013-14 has modified provisions pertaining to Dividend Distribution Tax (DDT). Earlier mutual fund houses were paying DDT on dividends distributed by debt funds other than those classified as liquid funds at the rate of 13.52% (Inclusive of surcharge and education cess) for all dividends distributed to individual investors and HUFs applying through Karta. However, Liquid funds were paying DDT at 27.04% (inclusive of surcharge and education cess). New provisions will now treat all debt oriented funds at par and DDT would be charged at a universal rate of 28.33% inclusive of surcharge and education cess). Dividends are tax free even today in your hands as they were earlier. New rules will come in effect from June 1, 2013.

Who will be hit the most?

Hike in DDT must be really disheartening to many of you especially to those who depend on dividend income. The new provisions will, in particular, affect some categories of debt oriented funds such as Monthly Income Plans (MIPs) and Liquid plus Funds. While dividends announced under MIPs form a regular income stream for many retirees; liquid plus funds are treated as a close substitute to liquid funds for their tax efficiencies.

If you have opted for dividend payout option for investing in a liquid plus fund; with new provisions coming in effect, your income from dividends may fall. On the other hand, if you have invested a big chunk in MIPs hoping to treat regular dividend disbursals as your pension (which we don't think is appropriate) then you'll be disappointed more than anyone else. With rise in the rate of DDT, your dividend income is set to erode. As remains the questions of other debt oriented funds such as income funds and gilt funds; they neither announce dividends as regularly as MIPs and Liquid plus funds do, nor do investors depend on them for regular income.

Worried? There's no need to panic

There's a way you can tackle this issue. If you have invested in liquid plus funds, you might opt for growth options provided you fall in 10% or 20% tax brackets as dividend distribution tax paid by your mutual fund might be higher than your own tax liability on capital appreciations. Moreover, you would still pay short term or long term capital gain tax when opted for dividend option, on appreciation in Net Asset Value (NAV) at the time of sale as compared to your purchase price. For those falling in the highest tax bracket of 30%, dividend option is still attractive. Short term capital gains on debt funds are clubbed with your income and are charged for tax at a rate applicable to you as per your slab. Long term capital gains are charged for tax at 10% without indexation or 20% with indexation.

But in case of MIPs wherein the main investment objective of an investor is to receive regular dividends, opting for growth options may not serve the purpose.

You must have heard about Systematic Withdrawal Plan (SWP). It is nothing but the reciprocal of Systematic Investment Plan (SIP). In SIP you invest a fixed sum every month for a predetermined time period. Under SWP you withdraw a fixed sum for specified time period or till your corpus becomes zero. SWP might just come handy now. SWPs may help you receive regular income and yet be a tax efficient option.

How it may work for you?

Although there's no precise formula to calculate as to how much should you withdraw every month opting for SWP route; you may do some approximations to arrive at the fixed sum that you need to withdraw. Typically, in case of MIPs, not all appreciations in the net asset value are distributed among investors as dividend. You may check out the dividend paying history of some well performing MIPs and average dividend announced by them can be taken as amount to be withdrawn through SWP. If you are more conservative, you may withdraw lesser than that, say just 80% of the average of dividends paid by a well performing MIP over last 3 or 5 years. Long term averages tend to be a lot more consistent.

Having said all this, we reiterate, dividend announced by any mutual fund, is not anything that paid over and above your investment or appreciation and hence one shouldn't treat it as a dependable source of earning. Those who want to generate regular income in their old age, should start planning for their retirement at a much early stage. Retirement planning could be done in isolation or it could form a part of your comprehensive financial planning.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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