In the Union Budget 2020, Finance Minister Nirmala Sitharaman announced a new tax regime that will allow higher income tax cuts if one let's go of most deductions and exemptions.
If you are one of the taxpayers who has made mutual fund investments or are planning to make one in the upcoming financial year, you may want to look at how the changes will work in your favour and how you could maximize on gains.
1. No tax-saving pressure
Under the new simplified tax regime, you do not have to think about which instrument to choose for tax-saving. You won't need to worry about lock-in periods or compromise with ROI (return on investment) from your mutual fund products.
Without the tax-saving pressure, investors can choose schemes that are in their financial interest and invest to create wealth as per their risk appetite, goals and liquidity needs.
2. Dividends could have a mixed impact
The dividend distribution tax (DDT) was removed to make dividends taxable at the hands of the receiver based on their income tax slabs. TDS (tax deducted at source) will be levied on any income paid by the mutual fund company to a unitholder if such an amount exceeds Rs 5,000 in a financial year.
It was not that dividends have been tax-free up to now. Companies had been deducting DDT before paying you a dividend, so the liability to pay taxes existed and was may have been higher than what you would have pay next year.
For the current financial year, dividend on equity mutual funds and debt funds is taxed at 11.65 percent and 29.12 percent, respectively (with cess and surcharge).
These dividends from mutual funds would be added to your income and taxed according to your income tax slab for FY21. If you are within the 20 percent income tax slab, you will stand to gain from the change, especially on debt mutual funds.
If you have been investing in equity mutual funds, you can go for the growth option that gives you the control of choosing to book profits when you want, unlike dividends, which are declared by the asset management company.
Additionally, with the power of compounding, you can have inflation-beating, better after-tax returns, that will help you create wealth for long-term goals.
Remember that LTCG (long term capital gain) on equity and equity-linked schemes are tax-free to the extent of Rs 1 lakh and could potentially be removed in the years to come.
If you are from the higher income tax slab, tax of dividends will still hurt you, especially if you are in the 30 percent bracket.
3. You may have to change your income flow strategy
Some investors, mostly senior citizens, used the dividend option in mutual funds for cash flow management.
As explained above, dividends you earned were never tax-free, making the dividend option not-so-favourable. Further, dividends are not guaranteed, which made the payouts inconsistent.
If you need a plan for regular cash flow, you can go for the growth option with systematic withdrawal plans (SWPs) which give predictable payouts. Further, with the removal of DDT, the scheme will also benefit from increased dividend yield that will lead to better appreciation in the NAV. However, make the switch after considering the exit load.