Friday, 14 February 2014

Mutual Funds: Zero Tax Debt Funds

Introduction: This blog entry is written with Liquid Funds and Ultra Short Term funds in mind.

Some Mutual Funds, for example, HDFC Liquid Daily Dividend give you dividend on a daily basis, and then reinvest it. At source.

Why do they do this?

The reason is interesting.

When they declare dividend, the NAV of the fund falls by an equivalent amount.

The declared dividend is reinvested so it becomes fresh investment.

So your money appreciates NOT as capital gain (NAV appreciation) but as reinvested dividend.

The effect of this that when you dissolve the fund, you get a lumpsum most of which is the principle itself.

So the tax liability is either very small, or negative, i.e., capital loss, although you have gained money.

This is useful because you don't have to wait for 365 days to reduce your tax liability on capital gain.

Quote, "ValueReasearchOnline:

"Consider opting for dividend reinvestment when investing in a liquid fund because dividends stripped will be reinvested as units and will be considered as fresh investments. This way the capital gain will be very low."

HDFC Liquid Fund, Daily Dividend. The NAV is static, so there is zero capital gain.

Further Information on Mutual Fund Taxation:

Dividends are Tax free, as per current financial policy of the Govt. of India.

But DDT (Dividend Distribution Tax), which is deducted before dividend distribution by the fund house, i.e., an indirect tax, must be taken into account to know what's suitable. DDT information is usually a part of the Offer Document of the fund scheme.

The following is a summary of direct taxation as well as DDT. This document is useful for the individual investor.

There is no TDS on Mutual Funds.

A good option would be the ultra short term fund. This fund's safety is comparable to that of liquid funds, and its DDT is 13.52%, as compared to DDT of liquid funds which is about 27%.

Less DDT means more dividend. At the cost of slightly higher risk, but risk is not always a bad thing.

Further reading: Ultra Short Term vs. Liquid.

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