This old article may have references to outdated tax rules and laws. For up-to-date information on taxation of mutual funds, refer to https://www.valueresearchonline.com/tax/
For mutual fund investors, dividends have always been a source of great confusion, misconceptions and suboptimal investment decisions. The reason for this is the use of the word ‘dividend’ for something that is not really a dividend, the blame for which must be laid at the door of the erstwhile Unit Trust of India which was the progenitor of this misleading practice.
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In comparison to dividends that investors receive from stocks, this word has a completely different meaning for mutual funds. In funds, dividends is not an additional income but just a withdrawal from your own money. If the value of your investment in a fund is R10 lakh, and the fund gives you R50,000 dividend, then after the dividend, the value of your investments will be R9.5 lakh. It’s just as if you had redeemed that amount. Even if you need money regularly as income, it is better to pick a non-dividend (growth) option and withdraw according to your own needs and schedule. In equity funds, as long as the investment is more than a year old, it is tax free anyway. In non-equity funds (including MIPs), dividends are taxed at 20 per cent and depending on your tax bracket and the age of the investment, there may be a small advantage in getting dividends if you need a regular withdrawal.
In any case, the common belief that the dividend option of funds is better because you get something extra is utterly wrong.