When you invest in a mutual fund scheme, you always have two options. First, you can have the returns generated by the system reinvested. Second, you can choose to receive returns on your investments at intervals. The first option is called Growth Option of a Mutual Fund while the second option is called “Income Distribution cum Capital Withdrawal” plans or IDCW plans (earlier known as Dividend Plan).
Therefore, IDCW plan is usually preferred by investors who need income from their mutual funds. On the other hand, the Growth Plan is chosen by investors who want to benefit from long-term asset appreciation, especially through equity investments, as all the returns the fund makes are reinvested.
Why SEBI changed Dividend to IDCW plan?
Income Distribution cum Capital Withdrawal or IDCW refers to the distribution of income from a mutual fund scheme, which can include both dividends paid by shares and capital gains from the sale of underlying shares from the scheme’s portfolio.
However, SEBI also wanted to emphasize that this income only comes from the value of the investor’s investment. In other words, it is a withdrawal of capital. According to SEBI, the term IDCW is a more accurate description of mutual fund dividends and that there should be no misconception in the minds of investors about mutual fund dividends.
What are the misconceptions about mutual fund dividends plan in India?
Misconception 1 – Dividends paid by mutual funds are actually paid by the underlying stocks in the scheme portfolio
Reality – Dividends paid by mutual fund schemes may also include dividends received from the underlying shares held by the scheme’s portfolio. It may also include gains booked on the sale of shares in the scheme’s portfolio.
Misconception 2 – Dividends received from mutual funds are extra income over and above the capital appreciation
Reality – Dividends received from mutual funds are not additional income or return over and above the gains investors make on redemptions. Mutual fund dividends replace capital appreciation and the same applies to investor capital. This is why the NAV of the dividend scheme falls by the extent of dividends paid to investors.
Misconception 3 – Dividend options of mutual fund schemes book profits regularly to pay dividends
Reality – The portfolio of the underlying growth scheme, dividends or any options of the mutual fund scheme is the same. When the fund manager books the profit, it is done at the scheme level i.e. for all options – growth, dividend or any other option.
The difference lies in the distribution of the scheme’s profits – if you have opted for the growth option, the profits are reinvested in the scheme and reflected in the NAV of the scheme’s growth option, whereas with the dividend option (now known as IDCW), a portion of the profit can be distributed among investors at the discretion of the fund manager /AMC. Investors should note that distribution of scheme profits is not mandatory for AMC to pay investors under the dividend option.
Is there any difference between dividends declared by mutual funds and companies?
- Companies pay dividends out of profit after tax (PAT). Generally, companies pay dividends after retaining a portion of the profit that goes into reserves and the company’s balance account for future growth. The management of the company decides how much of the profit should be paid out as dividends to shareholders and what amount should go into a reserve and surplus account.
- Mutual funds can only pay dividends from the accumulated profits of the scheme. The AMC decides the amount of dividend payout (IDCW) per unit. But whether the scheme pays dividends or not, the accumulated profits of the scheme belong to the investors and are reflected in the NAV (Net Asset Value) of the scheme.
- The net asset value (NAV) of the scheme always decreases after a dividend is paid. The NAV will fall proportionately and will be adjusted again after the dividend is paid. In contrast, a company’s stock price may or may not fall after a dividend is declared.
Should the investor invest in Growth or IDCW plan?
- In the Growth Option, the profits made by the funds remain invested in the system. For a long duration of the investment, the investor can earn a profit and so on. Also known as the power of compounding, it can be a significant factor in wealth creation for an investor.
- In IDCW, the profits made by the fund may be distributed to the investor partially or fully at the discretion of the fund manager / AMC. With an IDCW option, you lose the benefit of compounding because investors receive regular IDCW payouts.
- If the investment objective of investors is capital appreciation or long-term wealth creation, they should invest in the growth opportunity of a mutual fund scheme.
- If investors want regular cash flows from their investments, then they can opt for the IDCW option knowing that the distribution of income is at the sole discretion of the fund manager / AMC and that IDCW payout is not guaranteed in mutual funds. Investor can also invest in growth option fund and opt for swp for regular fund withdrawal.
- Tax Disadvantage of IDCW – The income the investor receives from IDCW is added to the gross taxable income and taxed at the investor’s income tax rate. Even from a tax point of view, IDCW is therefore at a significant disadvantage compared to the growth option, especially for investors in higher tax brackets. There is also TDS on IDCW if the total amount of dividends exceeds Rs.5000.
Capital gains on redemption of a growth option are subject to capital gains tax. Short-term capital gains in equity funds (investment holding period of less than 12 months) are taxed at a rate of 15% (plus applicable surcharge and tax). Long-term capital gains in equity funds (investment holding period of more than 12 months) are tax-free up to Rs 100,000 and thereafter are taxed at 10% (plus applicable surcharge and tax). In debt funds, short-term capital gains (investment holding period of less than 36 months) are added to your income, while long-term capital gains (investment holding period of more than 36 months) are taxed at only 20% after allowing indexation benefits.
Bottom line
IDCW plan help investor with support of income as capital withdrawal and Growth plan reinvest the returns from the mutual fund scheme to earn more returns and avail you of the benefit of compounding.
The another difference is that the Growth Plan is more tax-efficient than the IDCW plan. So if you are looking to reinvest the money and enjoy the magic of compounding, then there is no need to go through the hoop of IDCW plan. Instead, let the reinvestment happen automatically through the Growth Plan. The answer is as simple as that.
