Three Myths About Mutual Fund Dividends

Many Mutual Fund investors choose to invest into the dividend option of their selected schemes, instead of the growth option. If you’re one of them, you’ll want to make sure that you don’t harbour these fallacious beliefs about Mutual Fund dividends. Remember that switching from the dividend option to the growth option of a fund will attract loads and taxes, so you’re better off deciding your preferred mode of investment at the beginning.

They are profits earned over and above your fund value

Many investors choose the dividend option believing that they will earn higher returns than their growth-option selecting counterparts, as these dividends will be declared over and above their regular capital gains. In reality, dividends represent nothing but a portion of the capital gains themselves. Here’s how they work, in a nutshell. Say, your fund value (in the dividend option) has grown from Rs 1 lakh to Rs 1.5 lakh, and the fund house declares a dividend that translates to Rs 25,000 for you. Post the dividend pay-out, the NAV (net asset value) of the scheme will recalibrate itself to reflect the quantum of the pay-out. This is known as the “cum-dividend” NAV and will be lower than the “ex-dividend” NAV. In other words, your fund value will fall to Rs 1.25 lakh, after the dividend is declared.

They are always Tax-Free

While it’s true that Mutual Fund dividends are tax-free in your hands, not all of them are tax-free at the source. Only dividends arising from equity or equity-oriented funds (such as aggressive hybrid funds that invest more than 65 per cent of their portfolios into stocks) are actually completely tax-free. Dividends from all other funds (including Monthly Income Plans, international funds and gold ETF’s) are taxed at source at a high rate of 28.33 per cent. In other words, if your non-equity oriented fund declares a dividend amounting to Rs 100, what will be credited to your account is just Rs 71.67. It’s actually more rewarding to just choose the growth option and redeem the required “dividend” amount yourself, creating an artificial dividend in the process.

They are guaranteed

Many investors, especially retirees, choose the dividend option in their Mutual Fund schemes assuming that these pay-outs are guaranteed or assured in nature. In reality, dividends from equity oriented schemes can be extremely erratic, and these funds can sometimes go several months without paying a dividend. Even dividends from hybrid funds that have just 20 per cent-25 per cent of their portfolios invested into equities can vary dramatically in their pay-out frequency or quantum. Consider this: the dividends on Rs 10 lakh invested into Birla Sun Life MIP - II Wealth 25, a top performing Monthly Income Plan, would have amounted to roughly 81,000 in 2007 – and just 36,000 lakh in the next calendar year (2008) – a year on year drop of more than 50 per cent. If you’re looking for a more consistent cash flow from your portfolio - for instance, to meet your essential monthly expenditures, SWP’s (Systematic Withdrawal Plans) represent a much better option.