Tax on mutual funds with dividend reinvestment plan

Most mutual fund advisors suggest dividend reinvestment option to debt mutual fund investors in the highest tax slab because the option results in almost nil capital gains. This is because the dividends declared by the mutual fund are reinvested and because of it there will be no capital gains when the fund is sold. Debt mutual funds sold before three years attract short-term capital gains tax at the marginal rate applicable to the investor. This means the investor in the higher tax slab will pay 30 per cent tax on the short term capital gains. However, this method is not such a great windfall for investors in the higher tax slab as it is made out to be. Dividends are tax-free for investors, but mutual fund houses pay Dividend Distribution Tax of 28.33 per cent on dividends declared. So the real saving is only a few percent points.