Dividend Mutual Funds: Definition & Tax Implications

What are dividend mutual funds?

Dividend mutual funds are those which pay regular dividends to investors. Dividend mutual funds, therefore, create a source of regular income for investors in the form of dividend pay-outs.

How dividend mutual funds work?

Let’s understand the workings of dividend mutual funds through an example -

Suppose there are two corpuses of INR 10 lakhs each. One corpus is the growth mutual fund and the other is the dividend mutual fund. Suppose, after a year, both the corpus grew by 10% to INR 11 lakhs. Now, under growth mutual funds, the return earned, INR 1 lakh, would be reinvested in the fund’s portfolio. So, the corpus for growth mutual fund would become INR 12 lakhs. Under dividend mutual funds, however, a dividend would be paid. Suppose the fund manager decides to pay INR 50,000 as dividends to the investors. If there are 50 investors, INR 1000 would be paid to each investor as dividends. The remaining INR 50,000 would be reinvested in the corpus for better returns in the next year.
The entire return generated on the Assets under Management (AUM) of the dividend mutual fund portfolio is never distributed as dividends. Fund managers invest a part of the return as dividends and the remaining is reinvested. Reinvestment increases the corpus which, in turn, helps fetch better returns in the future.

Portfolio of dividend mutual funds

Dividend mutual funds usually invest in stocks which promise periodical dividends. Since dividend mutual funds have to pay dividends to their investors, the fund managers prefer stocks which also pay dividends so that the earned dividends can be passed on to the investors. The return generated by dividend mutual funds is a result of trading profit. The fund manager buys stocks at a lower price and then sell them when the prices are high. This creates a profit which is added to the Net Asset Value of the fund and is reflected as the returns generated by it.
The adding of profit to the Net Asset Value increases it. However, fund houses keep a cap on the maximum Net Asset Value which can be achieved by a dividend mutual fund. If the Net Asset Value crosses a predefined limit, the fund managers liquidate the returns and pay them in the form of dividends. As dividends are paid out, the Assets under Management reduce which, in turn, brings down the Net Asset Value.

Payment of dividends

Dividends can be paid every day, every month, every quarter, every six months or every year. The payment frequency is decided by the fund house and is usually fixed. When the investor invests in dividend mutual funds, the frequency of dividend payments is mentioned beforehand.
The rate and the amount of dividends is not guaranteed. Dividend payments depend on the performance of the mutual fund portfolio. If the capital market is experiencing volatility and the prices are falling, the fund might make a loss. In such a case, no dividend would be paid even though it was promised. Thus, the payment of dividends is not guaranteed under dividend mutual funds.

Incidence of tax

Dividend is an income in the hands of the tax-payer. However, such dividend earnings are not subject to tax. They are tax-free income which is recorded under the head ‘income from other sources’. The reason why no tax is levied on dividend income is because of the fact that the fund houses are already required to pay a tax on the dividends that they are distributing. A Dividend Distribution Tax (DDT) is payable by the fund houses which pay dividends on their mutual fund schemes. The DDT depends on the type of mutual fund on which the dividend is being paid. The rate of DDT is as follows –

• For equity mutual funds, dividends are taxed at a Dividend Distribution Tax of 11.648% including surcharge and cess
• For debt mutual funds, dividends are taxed at a Dividend Distribution Tax of 28.84% including surcharge and cess.

Dividend mutual funds are a way to offer you regular income in the form of dividends. If you want liquidity from your mutual fund investments without redeeming them, you can choose dividend mutual funds and avail liquid dividends. The dividends are also tax-free in your hands making them all the more attractive. So, choose a good dividend mutual fund and invest your money to earn regular dividends.