Mutual fund 'dividend' is a misnomer. And tax-inefficient, too

Thus, for a person who is investing in mutual funds, two options are available—the growth option, and IDCW.

The growth option of investing in mutual funds is where the profit made by the scheme’s portfolio is automatically reinvested into the scheme and the investor’s investment simply grows in value.

In the IDCW option, the accumulated profit made by the scheme is distributed to the investors. On selecting the IDCW option, investors have two choices: payout or reinvestment. In the payout mode, the accumulated income is paid out to the investors, like how dividend is given to investors for their stock holding. In the reinvestment option, the income is reinvested into the scheme by purchase of additional units with the distributed amount. The purchased units are added back to the existing holding of the investor.

So, while there is no income received in any form in the growth option, under the IDCW option the investor receives income either in terms of direct transfer or additional units. Let us understand the growth and IDCW options a bit more.

Regular income is not assured

An important factor that those opting for the IDCW option must keep in mind is that the decision to distribute income is that of the fund manager and is not set in stone. Mutual fund schemes are not obligated to distribute income and there is no specification on the payout rate or frequency of distribution. In fact, even if the fund house makes a profit, they may choose not to distribute it. Thus, for investors who have chosen the IDCW hoping to receive a steady flow of income, there is no guarantee that their requirement will be met.

Impact on net asset value (NAV) and returns

Be it the growth option or the IDCW option, all factors of the scheme, including the portfolio are the same. The only difference is the distribution of the accumulated income and how the NAV is impacted by the distribution of the income.

NAV is the mutual fund’s market value per unit; simply put, it is the cost per unit of investment in a scheme. It is the price at which an investor can invest or redeem one unit of that mutual fund scheme.

In the IDCW option, be it reinvestment or payout, the NAV reduces once the income is distributed. This is similar to stocks, where the share price falls post dividend declaration. It is important to note that even though investors receive income, the value of the portfolio is reduced by an equal amount. Thus, contrary to what investors believe, they are not receiving any additional income or gain. In fact, true to its name IDCW option only distributes income that already belongs to the investor by reducing his/her capital through withdrawal.

In the growth option, the accumulated profits of the scheme are automatically reinvested into the scheme resulting in the NAV of the scheme increasing. Thus, the NAV of units under the growth option is mostly higher than the NAV of units in the IDCW option. An investor can see this difference in NAV clearly by visiting the website of any mutual fund house, typing in the name of any scheme and comparing the NAV of the growth option and the NAV of the IDCW option.

Since there is no withdrawal of capital to pay investors in the growth option, the accumulated profits remain in the scheme and continue to appreciate in value over time through the power of compounding. Thus the growth option accelerates wealth creation for investors.

Tax inefficiency of the IDCW option

“Taxation of dividend from mutual funds has undergone dramatic changes from 1 April 2020. Previously the fund was paying dividend distribution tax (DDT) on the dividend declared; however, now the investor will be subject to tax as per his/her respective tax slab rate. Further, tax at 10% is also deductible at source (TDS) by the fund on such dividend, where the sum received is more than ₹5,000 per financial year," explains G.R. Hari, chartered accountant and partner at Manohar Chowdhry & Associates.

“This has made it painful for investors who have opted for the IDCW option. Such investors have to pay tax as per their income tax slab rate on the income distributed to them from the mutual fund investment. In fact, even in the reinvestment option, the additional units purchased from the income distributed will be treated as dividend and taxed at the slab rate," explains Hari.

In comparison, investors with mutual fund holding under the growth option are not liable to pay any tax until they make a profit at the time of redemption. Thus investors find the IDCW option less tax efficient compared with the growth option and those who fall in higher tax brackets veer towards the growth option.

However, in one scenario investors can use the IDCW option to reduce their tax payable. “Those resident individuals, whose taxable income, including dividend income, does not exceed ₹5 lakh may use the IDCW option to avoid paying tax on the income distributed. Such investors can claim a rebate under section 87A, and effectively pay no tax on the income received from the fund," explains Hari.

Further, an investor planning to switch from the dividend option to the growth option will have to pay capital gain tax on any profit as switching from one option to another amounts to redemption.

Choosing between the growth option and the IDCW option

Retirees and older investors, who require additional sources of income, may consider the payout option while investing in mutual funds. But it is pertinent to note that even though income is distributed to the investor, there is an equal reduction in the capital. “Dividend from stocks and income distribution from mutual funds should not be thought of as the same. Income distribution from mutual funds is not predictable and guaranteed. Hence those looking for regular dividend income are advised not to rely only on the IDCW payout option. If regular income is the objective, a retiree should instead opt for the systematic withdrawal plan (SWP), which allows periodic redemption of the mutual fund investment to ensure the need for regular cash inflow is met," explains Vishal Dhawan, Certified Financial Planner and Founder of Plan Ahead Wealth Advisors. Further, retirees must also note that the IDCW option in debt mutual funds has an increased chance of income distribution compared with income distribution in equity mutual funds.

Another option some retirees and those who require regular cash inflows, are looking at are Dividend Yield Funds. These funds specifically invest in companies that have a high dividend yield. This increases the chances of income received for such investors. However, opt for the growth option of such funds to reduce your tax outgo.

Some investors also veer towards the IDCW option when the markets are doing well. The logic being that the better the markets fare, the more the NAV will increase resulting in income being distributed by funds. While this strategy may work in bull markets, the volatility and cyclical nature of equity markets will make it foolhardy to assume that such good times will last forever and is a futile attempt at timing the market.

For younger investors, or investors who do not require any regular income, it is advisable to opt for the growth option. “Specially for younger investors who start off investing in mutual funds with smaller amounts, the IDCW option may prove counter-efficient. The lower investment will earn very minimal income. On payout such small amounts are mostly consumed for personal expenses or requirements. Hence, what would have compounded in value under the growth option is now simply being used up," explains Dhawan.

To summarize, if your priority is to grow your portfolio in value and wealth creation over a long time horizon, the growth option is preferable over the IDCW option.