What is dividend tax?

A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.

Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.

The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.

What is dividend tax?

Dividends are paid from the profit made by mutual fund schemes exclusively from investment activities related to the scheme portfolio and are at the discretion of the trustee. If the scheme produces a loss in a falling market, trustees may decide to waive the announcement of dividend payments. Since the dividend is a profit or income, it is considered taxable and the applicable dividend tax is called dividend distribution tax (DDT). Previous dividends were taxable at source, i.e. the scheme had to pay the DDT before distributing it to investors. This obviously reduced the amount of dividend payout, but it was tax-free in the hands of investors.

With effect from 01 April 2020, DDT was abolished and dividends from mutual funds were made taxable in the hands of investors. Now dividend income will be considered as income from other sources, and investors will have to pay taxes on it according to their individual tax plates. So the benefit or loss due to mutual fund dividend tax compared to the previous DDT tax regime will depend on the investor’s tax bracket.

Previously, all investors received dividend payment after a uniform rate of dividend distribution tax was deducted from the scheme. DDT had an equal impact on all investors because it reduced the distributable surplus of the scheme by applying a uniform tax rate depending on the type of scheme. This is no longer the case. While investors will receive dividends in proportion to their investments, an investor in a higher tax bracket will end up paying a higher tax on dividends received than someone in a lower tax bracket.

The removal of DDT made it a level playing field for growth and dividend options within a scheme. So investors will now need to weigh the benefits of opting for a dividend option in terms of the effective tax rate (including cess and premium) applicable to them and the need for dividend income.

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