Unlike equity funds, where you get to choose between a dividend and a growth plan enabling you to not only get tax free dividends but also the entire amount to fund your priorities, your returns on debt funds may vary depending on your choice.
Debt funds carry tax
Your debt funds are bound to imply taxes depending on the type and tenure of the debt fund you choose to invest in. DDT(Dividend Distribution Tax) and capital gains tax are the two primary taxes that are levied on your debt funds.
Except for liquid funds, all debt funds, pay a DDT of 13.80% (12.5% tax + 7.5% surcharge + 3% education cess). This is a tax that is paid at the time of dividend distribution and the fund pays it out of the dividend it earmarks for distribution. Therefore, your returns drop if you choose the dividend plan. Liquid funds pay a higher DDT of 28.325%.
Additionally, if you withdraw from your debt fund before a year, depending on your income-tax bracket, you pay a short-term capital gains tax of 10.30%, 20.60% or 30.90%. Long-term capital gains in debt funds are taxed at 10.30%.
Dividend or Growth ?
It is very important to focus on your financial objectives so that you need not enter into a debt by taking a personal loan or any loan for that matter. Although tax implications must be borne in mind, your focus should be mainly on your financial objectives.
Now, if you want to invest into debt funds for more than a year, opting for a growth plan wold be feasible, unless you wish for dividends. But, if you wish to invest for less than a year then, investing through a systematic transfer plan and then transfer systematically to equity fund is best advised.
From the taxation point of view, the dividend plan works better. For example, assuming that you are in the highest tax bracket, you pay 30.90% short-term capital gains tax every time you switch to an equity fund against 13.840% DDT, makes the former option more feasible.
Investing in a dividend plan in an ultra short term fund or a liquid fund may get you dividends every week or even a fortnight but you will be burdened with your account statements each time your fund declares a dividend. The eventuality of which will lead you to spend your dividend amounts reducing the value of your fund.
So, opting for a dividend reinvestment plan is beneficial in such case wherein you can pay less tax and even get entitled for your dividends but those dividends will again be reinvested.