Want regular income? Don’t go for debt funds

Imposition of dividend distribution tax lowers post-tax returns

Debt funds that usually generate higher returns over a medium term, are often considered a good alternative to your humble bank fixed deposits.

But if you are considering debt funds as a substitute to bank deposits only for seeking regular flow of income by opting for the dividend option, think again. Here’s why:

Where they differ?

Debt funds are poor choices for investors seeking income generation.

For one, there is no guarantee on the monthly income, as dividends are paid only from surpluses and not from capital. If the fund does not perform well, it may not declare dividends at all. Hence, choosing the dividend option only for earning regular income may not be such a good idea in the first place.

Then there is the tax aspect to consider. While dividends declared by funds are not taxable in the hands of the individual, the fund house has to deduct taxes before distributing dividend to investors.

All debt funds attract a dividend distribution tax (DDT) — the effective rate works out to 28.8 per cent. Hence, you would end up getting ₹1.4 on a dividend of ₹2 declared by the fund. The NAV of the fund, though, gets adjusted by the gross dividend (₹2).

Dividend vs withdrawal

For investors in the 10 per cent or 20 per cent tax bracket, the dividend option clearly loses the plot on tax efficiency, given the high rate of DDT.

If your need is such that you require regular cash flows, then the Systematic Withdrawal Plan under the growth option (provided there is no exit load) would be a better bet. Under this, gains withdrawn from your debt fund will be taxed at your slab rate, which for a person in the 10 or 20 per cent tax bracket works out better than the dividend option.

Let us assume that you invested ₹1,000 in a debt fund. The NAV of the fund grows to ₹1,100. If you opted for the dividend option and the fund declares dividend of ₹50 then, after paying a tax of ₹14.4, the fund pays ₹35.6 as dividend. The NAV of the fund, however, goes down by ₹50. Hence, your ₹1,000 investment has ideally been giving you a return of ₹85.6 (capital gains + dividends).

If, instead, you simply withdraw part of the gains, say ₹50 from the fund, you will have to pay tax according to your slab rate.

If you fall under the 10 per cent or 20 per cent tax bracket, then your returns work out to a higher ₹94.5 and ₹89.7 respectively for the same investment.

For those in the 30 per cent tax bracket though, choosing the dividend option may generate slightly higher post-tax returns than a withdrawal plan.

Why dividend at all?

Dividend or SWP may interchangeably turn out to be a better deal for a different set of investors. But riding on debt funds for your regular income is a poor choice, nonetheless, given the tax burden that you have to bear under both options.

If dividend options under debt funds are such a poor deal, why do funds offer them at all? Till about 2004, there was no DDT. Hence, dividend option for debt fund investors automatically offered better post-tax returns than bank deposits.

As DDT kept creeping up, investors found another way to work around it.

Opting for SWP under the growth option of debt funds, proved to be more tax-efficient, until 2014, when gains made on debt funds held for more than one year, were treated as long-term capital gains and taxed at 10 per cent with indexation.

But, post the 2014 Budget, capital gains made on debt funds held for less than three years, are taxed as per slab rates, just like in the case of FDs, removing the tax advantage. Hence, given the many tweaks in tax rules in recent years, your investments in debt funds are ideally not for income generation. You must, instead, consider them as a vehicle to grow your wealth.

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