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Given a choice between paying tax at a higher rate or a lower rate on the same instrument, what would you choose? Or, to rephrase the question: given a choice between paying tax at 30% or at 12.5%, what will you choose? The obvious answer would be 12.5%, since it is lower. However, in case of debt funds, paying tax at the higher rate actually works out to be more beneficial.
Why?
Let’s assume two investors - Naresh and Sachin - in the highest income tax bracket of 30% invest in the same debt mutual fund. They both invest Rs 10 lakh.
Naresh opts for dividend option, which is taxed at the rate of 12.5%. His objective is to make the investment, sit back and enjoy the tax-free income. The scheme has earned a distributable profit of 10%. This works out to Rs 1 lakh on the originally invested capital of Rs 10 lakh for Naresh.
On the other hand, Sachin has chosen the growth option and withdraws Rs 1 lakh just at the end of one year. Note that this is the same amount as Naresh receives as dividend. However, for Sachin the withdrawn amount represents short-term capital gain.
Now, 10% of Rs 10 lakh works out to Rs 1 lakh. But Naresh gets a dividend of only Rs 88,889. Why? The mutual fund has to pay a distribution tax of Rs 11,111. The math is simple: 11,111 is 12.5% of Rs 1 lakh.
How short term capital gains tax is better
Let’s see what happens in Sachin’s case. Since he has chosen the growth option, in one year at 10%, the NAV would have grown from Rs 10 to Rs 11. To redeem Rs 1 lakh, he would need to sell 9,091 units (100,000/11).
Though Sachin has sold units worth Rs 1 lakh, the entire amount is not taxed. It is only the capital gain that will be taxed. First we need to calculate the capital portion in the amount he withdrew. That works out to be Rs Rs 90,910 (1,00,000 x 10/11). Thus, the capital gain works out to just Rs 9,090 and the tax thereon at 30% is Rs 2,727. Net take-home for Sachin is Rs 97,273, compared to Rs 88,889 for Naresh, almost Rs 10,000 higher.
In the end, both have their original investment intact. In other words, 30% works out to be lower than 12.5%. Looking at it another way - when the mutual fund pays you income, it’s called dividend. Instead of dividend, if you withdraw the same amount of money from the mutual fund, it’s short-term capital gains.
Think what if Sachin was in a lower tax zone? His take-home would be much higher. No such chance for Naresh. He would have to bear the same amount of tax, notwithstanding his tax zone.
To conclude
The general misconception is that there is no advantage in earning short-term gain, since it is taxed at the normal rates. However, what may be lost sight of is that the advantage flows from the fact that a large portion of withdrawals is capital and, simultaneously, an equal amount from the income gets converted into capital. In other words, you are consuming capital and investing income.
Obviously, this principle would work only for the long-term investor. If you have a short-term view and were to sell your entire holding at one go, this investing strategy will not work.
Look at it any which way, the only way to make the dividend truly tax-free is to avoid it altogether. The rule is simple - no dividend, no tax.
