Income Tax on Equity and Debt Funds for Dividend and Growth

In Equity funds, Growth and Dividend reinvestment options mean the same, as there is no DDT for Equity funds. These two options are almost the same from pretax returns point of view. However, post tax returns would vary since income tax implications under both the options can be different.

For example, if you redeem your investment within one year, then your post tax gain in dividend reinvestment option would be more if dividends are declared after the investment. This is because under growth option, the entire gains would be taxed @11.33% (assuming that the investor is in the highest tax bracket and same assumption is followed throughout) as short term capital gains while in dividend reinvestment option, the total gains minus the dividend would be taxed as short term capital gains.

However, if you redeem your investments after one year assuming that income tax laws do not indeed change, then you may be slightly (in fact very minutely) better off with Growth option. In Growth option, all your gains would be long-term capital gains and hence would be fully exempted. However, in dividend reinvestment option, the capital gain on dividends reinvested during 12 month period immediately preceding the date of redemption would be taxed as short term capital gains @ 11.33%.

In future, there could be changes in relevant income tax laws such as those pertaining to Dividend receipt, dividend distribution, and long term capital gains on equity oriented mutual funds.

Dividend reinvestment option would score over Growth option since future changes in income tax laws would not affect any dividends already distributed. To that extent, you are assured of tax free gains.

In summary, in case of equity oriented funds, you should consider dividend reinvestment option more tax efficient than Growth option.

For Debt funds, Growth is a better option because they are subject to DDT.

Let’s have a look at taxation of debt funds.

Long term capital gains on debt funds are taxed at your option either at 11.33% without indexation benefit or at 22.66% after allowing indexation benefit. Short term capital gains are taxed at 33.99%.

Dividend distribution tax is applicable at 22% for liquid and money market funds and at 12.4% for other debt funds.

As you can see, Growth option is generally better in case the investment is intended to be held for more than one year. While dividend reinvestment option would score in case the investment is intended to be held for up to one year.