If you're worried about the hike in the dividend distribution tax for non-equity mutual funds, switch to the growth option of the scheme and then start a systematic withdrawal plan

After the recent Union Budget, the dividend distribution tax (DDT) on all non-equity funds has been doubled from 12.5% to 25%. These include income funds, monthly income plans, gilt funds, ultra short-term funds, etc. Once you consider the additional surcharge, which has also been increased from 5% to 10%, and education cess (3%), the final tax liability will work out to 28.33%. This is significantly high for any investor who falls in the first two tax brackets, with applicable tax rates of 10.3% or 20.6%. As is evident from the table (Mutual funds more...), the benefit is minimal even for investors who fall in the next tax bracket with a rate of 30.9%. This means that the dividend option has now become nonviable for all investor classes.

Why did the finance minister raise the DDT? To mobilise deposits, banks had asked the finance minister to provide better tax treatment to bank fixed deposits (ie, increase the limit of TDS from 10,000, make bank interest tax-free in the hands of investors, etc). Instead, the finance minister has increased the DDT on all non-equity funds.

Though this move seems to have reduced the tax efficiency of mutual funds to a large extent, there are still ways in which investors can benefit from it. The strategy is to shift from the dividend to the growth option. This will not help if your holding period is less than a year since short-term capital gains are taxed at marginal rates, as in the case of bank FDs. However, there is a substantial tax advantage for the long term (if the units are held for more than a year). This is because the long-term capital gains are taxed at preferential rates (10.3% without indexation, or 20.6% with indexation), not at the marginal tax rates. This means that the growth option of income funds continues to remain the best bet for anyone who wants to accumulate wealth to meet long-term goals.

What happens to the investors who want a regular income from their investments? As the dividend option is no longer feasible, such investors can first choose the growth option and, after a year, switch to a systematic withdrawal plan (SWP). These plans allow you to withdraw money on a regular basis (monthly, quarterly, semi-annually, annually, etc) to meet your needs. Several mutual funds offer two alternatives—fixed withdrawal option, wherein you get a fixed amount periodically; and appreciation withdrawal option, where you can restrict your withdrawals to the appreciation in the holding. If you're not satisfied with your first choice, you could reduce or increase the withdrawal amount, or the periodicity, or even terminate the SWP later on.

More importantly, these SWPs are tax-efficient. Firstly, no tax is deducted at source on these withdrawals. Secondly, the actual tax liability will be much lower than the interest earned from bank FDs. Let us consider a person who has 10 lakh to invest and wants regular income. For simplicity, we will assume that both the FDs and the non-equity mutual fund generate 10% yield. The income generated from the bank FD ( 1 lakh) will be taxed at the marginal rate. So, if the investor is in the 30.9% tax bracket, his tax outflow on the interest earned will be 30,900.

In the case of the non-equity mutual fund, while the investor will receive 1 lakh from the SWP, the entire money will be nontaxable. This is because a part of it will be the investor's principal. Assuming that the fund's net asset value (NAV) was 10 at the time of investment, it would have grown to 11 after a year at 10% growth rate. So, the investor will have to redeem only 9090.9 units to get the required 1 lakh. The bulk of the value (that is, 90,909 = 9090.9 x 10) will be the principal component in the first year. This means that the capital gains for the first year will be only 9,091 ( 1 lakh - 90,909) and 10.3% tax on this will be just 936.