Hidden costs in mutual funds: Expense ratio, Entry and exit load, Dividend distribution tax

Understanding the various costs and taxes associated with mutual funds can help you make informed investing decisions.

Hidden costs involving mutual funds that you need to know

Mutual funds offer an inexpensive way to invest in the stock market and have your funds managed by professionals. Your investments with a fund house or Asset Management Company (AMC) are subject to various charges and taxes that you should be aware of. 

Expense ratio

In exchange for their services, the fund house charges a fee as a percentage of your investment value. This fee compensates the management as well as takes care of other investment-related expenses such as administrative cost, marketing, and GST. The percentage charge or expense ratio varies from one AMC to another, as well as across mutual fund schemes.

These charges are calculated on a daily basis depending on the total Assets Under management (AUM) and deducted from the investor’s unit holdings. The NAV of a fund is declared after adjusting for these expenses.

To ensure that investors are not subject to unnecessarily high charges, the Securities Exchange Board of India (SEBI) has stipulated a slab-wise structure on the expense ratio that a fund can charge on an annual basis (see table) below.

Average weekly net AUM Cap for equity schemes  Cap for debt schemes
Up to Rs 100 Crores 2.50% 2.25%
Rs 100 to Rs 300 Crores 2.25% 2%
Rs 300 to Rs 600 Crores 2% 1.75%
Balance AUM 1.75% 1.50%

Related: Top Performing International mutual funds to invest from India, Global funds, US and China Equity Funds

The size of the fund has a direct correlation with the expense ratio, which in turn impacts the returns generated. 

Entry and/or exit load

Some funds may levy an entry and/or exit load on specific schemes, which is a one-time charge levied at the time of buying or selling a mutual fund. SEBI has implemented a no-charge rule on mutual fund investments, which means your entire corpus will be invested without any deductions. 

An exit charge is levied when investors wish to redeem investments before the minimum prescribed investment period. The exit load can vary between 0.5% and 3% depending on the mandate of the fund. The same is deducted from the redeeming NAV before the proceeds are paid out. 

If the investor holds the investment beyond the specified period, no exit load is charged.

Related: Best mutual funds for investment in 2021

Dividend Distribution Tax

AMCs may distribute a part of the unrealised gains as dividend to the investors. Until March 2020, the Dividend Distribution Tax (DDT) was payable by the fund house. However, the with the Finance Act 2020, all dividends paid from 1 April 2020 will attract a TDS of 10% on any dividend income above Rs 5000. On account of the COVID-19 pandemic, the government had reduced TDS to 7.5% for dividends paid out till 31 March 2021. 

Investors need to be mindful of the tax deduction as a part of the gains received from mutual fund investments. Investors cannot claim an deduction in lieu of expenses towards these investments, but individuals whose total annual income is below the exemption limit of Rs 2.5 lakh can submit Form G to the AMC to claim a dividend without TDS.

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