Mutual funds vs direct stocks: The hidden tax advantage on dividends that investors should know about

If you are investing in mutual funds, you may be getting a hidden tax benefit that you might not be aware of. It is related to the tax on dividends—a tax that mutual fund investors do not have to pay directly. But if you invest in stocks and receive dividend income, the tax on it can go up to 30%, depending on your tax slab. Here's what investors need to know about the dividend tax advantage in mutual funds. How much tax does an investor pay on dividends from stocks? Nilesh D Naik, Head of Mutual Funds at PhonePe, said, 'For resident Indians, dividends from stocks are taxed at the applicable personal income tax slab rate'. Sougata Basu, Founder and CEO, CashRich, added that dividends have been taxed in the hands of investors since April 2020, after the dividend distribution tax was abolished. They are treated as 'income from other sources.' For an investor in the 30% slab, with 4% cess, ₹1 lakh of dividend income translates into ₹31,200 in tax. Surcharge, capped at 15% on dividend income, can push the effective rate to around 36%, he added. Who pays tax on dividends earned by a mutual fund from its underlying stocks? If a mutual fund receives dividends from stocks it has invested in, Basu said, those dividends are not taxed at the scheme level. Neither the scheme nor the AMC pays tax on these dividends. It also does not affect the total expense ratio (TER), which covers fund management, distribution, custody, registrar and similar costs. Income tax is not included, Basu added. Naik said these dividends are reflected in the scheme's Net Asset Value (NAV). Consequently, when investors redeem their investments, they are subject to long-term or short-term capital gains tax, depending on their holding period. Can dividends boost long-term wealth through fund NAV rise? Basu explained that, 'The NAV does not jump on dividend day. The stock goes ex-dividend and drops by the payout, and the fund holds that much more cash. The wealth effect comes later. In the Growth option, that cash is reinvested in full, no tax taken out, and compounds until redemption'. Naik said that since mutual funds do not pay tax on dividends from underlying stocks - with gains instead reflected in the NAV - investors in higher tax brackets can benefit. However, given that the average dividend yield in Indian equities is only 1% to 1.5%, the overall impact of this tax efficiency is limited. Can direct stock dividends be more tax-efficient for investors with low income? Yes. Naik said investors with total income below ₹12 lakh may find direct dividends more tax-efficient because dividends are taxed as normal income, while equity long-term capital gains are taxed at 12.5% after the applicable exemption. A dividend from a share is 100% income. A redemption is partly your own capital coming back. Redeem ₹12 lakh of units bought for ₹10 lakh, and only ₹2 lakh is the capital gain. For someone with no other income, that ₹2 lakh sits inside the basic exemption and the tax is zero, Basu explained. How is IDCW taxed for mutual fund investors? From April 2021, SEBI renamed the dividend option in mutual funds to 'income distribution cum capital withdrawal (IDCW)'. It comes in two forms: payout and reinvestment. Both are taxed like a stock dividend at the investor's slab rate, Basu explained. He said the NAV drops by the amount paid. The reinvestment form is the worst of both. It is taxed as income, then reinvested at a fresh cost. Nothing is gained, and tax gets paid. Most retail investors should avoid it. Is the Growth option more tax-efficient than IDCW? Naik said that for investors in higher tax brackets where the personal tax slab rate is 15% or higher, growth options of mutual funds may be more tax-efficient than the IDCW option. The only case where IDCW is not worse is the zero-slab investor. Even there, investors can use an SWP from the growth option to generate regular cash flow, with tax applying only to the gain portion of each withdrawal, Basu added.