If you’ve looked through a mutual fund application and come across the same plan with “Growth” and “IDCW” (Income Distribution cum Capital Withdrawal, which was previously known as a “dividend”), you must have thought of the basic difference between the two options and whether there is an advantage in choosing the dividend option.
This is one of the significant reasons behind the confusion of novice investors in India, but even some experienced investors hold erroneous beliefs regarding the working of dividend mutual funds. This guide resolves the ambiguity, explains the mechanism of operation of the funds, and tells you whether it should form a part of your portfolio.
What Are Dividend Mutual Funds?
A dividend mutual fund is not in itself a category of fund. Instead, it represents one of the exit strategies that conventional mutual fund schemes offer their investors. When investing in a fund, you generally have the following options:
- Growth option – Profits generated by the fund continue to be invested as capital gains. Only upon redeeming your units do you access the profits.
- Dividend/IDCW option – The fund pays you the profits it made periodically instead of rolling them over into the next cycle. This payment could be in the form of cash or additional units as part of a reinvestment plan.
When people refer to “dividend mutual funds,” they usually highlight that the investor has chosen the IDCW scheme instead of compounding their investment over time.
In 2021, SEBI mandated that mutual funds change from the term “Dividend” to IDCW – Income Distribution cum Capital Withdrawal – since the term ‘dividend’ was misleading. The reason is that, unlike an actual corporate dividend, which is distributed from actual profits, a mutual fund payout could be from your own capital returned to you instead of being new profits. This differentiation has legal ramifications that many of the novice investors are unaware of.
How Do Dividend Mutual Funds Actually Work?
This is the basic way this works:
- To earn a return, the fund manager has to invest in something — either stocks, bonds or a mix of both, as dictated by the nature of the fund.
- Then, as per the practice of such funds (which means that there’s no guarantee when these payments will happen), certain asset value will be distributed among unit holders.
- Since the fund paid something out, its asset value drops by the same amount of money distributed to investors. This is a very important detail that many people miss — a distribution isn’t a thing which you “get on top” of your investment value. It’s your own money coming back to you, and it reduces the value of your units correspondingly.
- The funds are either credited to your bank account in cash, or if you chose reinvestment option, more units are bought at the NAV of the fund after the distribution.
This is fundamentally different from how dividends worked with single stocks. In case of a company’s dividend payment, the company pays off its profit and no drop in share price occurs at the same moment.
Growth vs Dividend (IDCW): The Real Comparison
The two investment strategies discussed above can be differentiated based on the following aspects:
Compounding Potential: The Growth option allows the whole investment amount to remain in the fund and grow over time. The IDCW option, on the other hand, withdraws capital and supplies less money compared to the Growth option. The gap between the two strategies increases in 10-15 years.
Regular Income: This is where IDCW excels over Growth. If you require a regular income from your investment, which is possibly the case if you are retired and need extra money to use, then you can receive money automatically with the help of an IDCW investment.
Taxation: This topic is of utmost importance since it has changed drastically in recent years. IDCW payments are included in your taxable income and taxed at the specific tax slab rate. The fund house will deduct TDS if the IDCW payment exceeds certain thresholds during the financial year. As far as Growth options are concerned, income tax is not applicable until the time the units are redeemed and may be at a lower capital gains tax rate depending on the duration of holding.
Behavior of NAV: Generally, the NAV of Growth options will continuously go up because of the compounding effect, while the NAV of the IDCW option will be reduced each time by the amount of payout. Therefore, in theory, it would seem that the NAV of the IDCW grows slower than the NAV for the Growth option. However, it is not true since the overall amount you received (payout + remaining NAV) is the same for both options, in practice, minus any taxes and compounding prospects.
Flexibility and Control: Thanks to Growth options, you have the power to decide when to redeem your money and realize your profits. With IDCW, you do not have the liberty of deciding when money goes into your account or how much tax you will pay.
Who Should Consider Dividend Mutual Funds?
While keeping in mind the disadvantages of taxation, IDCW is still a good option for some. It can prove to be a good option for the following people:
- Retired employees or people in need of regular funds from investments. This is the easiest way for people to have a steady cash flow from investments without requiring them to regularly track their redemptions.
- Investors who fall in a low tax bracket where the tax burden from IDCW payments is less severe compared to that of someone who falls in the 30% bracket.
- People with poor investment discipline finding it difficult to not be tempted to sell all of their investments whenever the market faces a downturn.
Who Should Avoid It?
- For long term wealth creators who want to optimize their returns through the compounding effect – The Growth route is usually the better choice.
- Investors falling under higher tax slabs, because tax implications on a regular basis would reduce your gains substantially.
- When you are investing towards some objective in the future, like a retirement fund, child’s education or purchasing a home.
Common Misconceptions About Dividend Mutual Funds
The concept that “I am receiving extra returns on my investment because of dividend funds” is actually not true. The NAV itself goes down by the payout amount, implying that you are only getting back your original investment in parts and not getting extra returns on your investment.
A high dividend yield does not necessarily indicate higher performance for the fund. Paying out a high IDCW does not mean that the fund is better managed; it merely shows that the fund has decided to distribute its profits rather than reinvest them.
The fact that dividend funds are said to be safer than growth funds is also incorrect. Both types of funds are linked to the same portfolio, and the risk capability of the investment manager in charge determines which one is safer.
How to Decide Between Growth and IDCW
Think about these questions before making a decision:
- Will you need to generate income from this investment now, or are you looking for long-term wealth accumulation? The answer is “growth.”
- What tax bracket do you fall under? Higher tax bracket investors typically lose bigger amounts of money to IDCW’s fixed tax rates as opposed to paying capital gains tax under the growth option.
- Do I think I will be able to stick to the investment without need for periodic income withdrawals being a source of temptation to spend money?
Final Thoughts
Dividend mutual funds, now more appropriately called IDCW plans, do not have magical qualities that can help you earn money on top of the investment experts say that they simply offer you a different manner of obtaining the same underlying returns produced by the selection of this investment type which comes at the expense of a lower ability to compound earning and poorer taxation for the majority of clients.
For most investors whose goal is to accumulate wealth in the long run, the Growth choice is still the smartest option but if constant income is necessary especially when someone enters retirement, the IDCW option has its own importance in a well-designed savings model.
The final decision will rely on the investor’s cash flow requirements, tax implications, and investment period not on the seemingly most beneficial choice. If a person has any doubts, it makes sense to talk to an experienced adviser who can do a thorough assessment of the financial state of a person.
Frequently Asked Questions (FAQs)
Is it good to invest in dividend mutual funds?
Investing in dividend yield funds can be beneficial if you’re looking for stable companies and less volatility, but they might not outperform growth funds in the long run.
How do dividend mutual funds work?
In order to pay dividends to investors, mutual funds must first receive revenue from their underlying investments, such as realized capital gains, bond interest, and stock dividends.
How to get 50,000 dividends per month?
A substantial total investment, often between ₹1.2 crore and ₹2 crore depending on an average dividend yield of 4% to 5%, is required to receive 50,000 in dividend income each month (600,000 annually).
What happens to dividends in mutual funds in India?
Mutual fund dividends in India are called IDCW (Income Distribution cum Capital Withdrawal). On declaration of dividends, the distribution is made out of realized gains or distributable surplus of the scheme and NAV of the fund falls down by an amount equivalent to dividend distributed.
How to make 1 Cr in 3 years?
You either need a very large monthly savings amount or concentrate on high-income career advancement, business profitability, and aggressive high-return tactics in order to make 1 crore (10 million) by pure investment in three years.