Mutual funds differ considerably from stocks, and understanding the terms is essential. A mutual fund investor needs to be familiar with various strategies and terminology to trade effectively.
To invest efficiently as a mutual fund investor, you must understand direct, regular, growth, and dividend concepts. Growth and dividends are the distribution methods for profits, whereas regular and direct are the investment modes.
Growth and dividend plans are two sides of the same coin since mutual fund schemes’ growth and dividend plans invest in the same financial instruments. However, unlike growth plans, dividend plans provide profits to investors.
A dividend program pays out returns based on the number of units you own. This article defines everything about IDCW in mutual funds.
What is IDCW in a Mutual Fund?
IDCW stands for Income Distribution Capital Withdrawal in mutual funds. SEBI changed the name of dividend schemes to IDCW in Circular Number: SEBI/HO/IMD/DF3/CIR/P/2020/194 dated 5th October 2020 to highlight the schemes’ goals. The new regulation became effective on 1st April 2021.
In addition to changing IDCW, SEBI also modified the names of “Dividend Reinvestment” to “Reinvestment of Income Distribution” and “Dividend Transfer” to “Transfer of Income Distribution and Capital Withdrawal.”
As a result, on 1st April 2021, all mutual fund houses that offered the three above mentioned schemes changed their scheme names. Therefore, you must invest in an IDCW scheme today rather than a dividend mutual fund scheme if you want to invest in a dividend mutual fund scheme.
IDCW signifies that a portion of the investor’s capital can be distributed as a dividend. In general, mutual fund companies announce dividends based on the excess funds raised by the scheme.
While in a growth scheme, the excess cash is used to raise the NAV (Net Asset Value), since the dividend is paid out in an IDCW mutual fund, the NAV barely changes. As a result, the NAVs of IDCW mutual fund schemes move far more slowly than the NAVs of Growth schemes.
Dividend Plans in Mutual Funds:
When investing in a mutual fund scheme, you generally have two options: Growth Plan and Dividend Plan.
So, while the underlying portfolio of the Dividend Plan and Growth Plan are identical, the difference is in how the scheme’s returns are used in both plans.
For example, you can receive your investments’ profits regularly under the Dividend Plan.
Consider that you hold 10,000 units of a mutual fund scheme. The fund announces a dividend of Rs. 1 per unit.
You will receive Rs. 10,000 as a dividend in such a scheme.
Misconceptions About Mutual Fund Dividends:
1. Dividends from the underlying stocks in a mutual fund are paid as dividends.
Reality: Dividends from mutual funds may include dividends from the underlying stocks. Profits from selling stocks in the scheme portfolio are also included.
2. Mutual fund dividends are extra returns in addition to capital appreciation.
Reality: Dividends from mutual funds do not constitute additional returns to capital appreciation. Instead of capital gains, mutual fund dividends are used.
3. Mutual fund dividend options generate profits regularly.
Reality: A scheme’s growth and dividend option underlying portfolios are identical. Profit booking occurs at the scheme level, i.e., for both dividend and growth options. The way the profits are allocated differs.
The revenues from the growth option are put back into the scheme. In the dividend option, AMC may distribute all or part of the profit to the investors.
Why did SEBI Switch from Dividend to IDCW in Mutual Funds?
Dividends are extra profits you get in addition to your investment. However, this was different with mutual funds. The NAV of the fund decreases by the same amount when you earn gains from your mutual fund scheme.
As a result, you would have to withdraw your own money since there is no gain or additional compensation. Therefore, SEBI changed the name of the profit to “distribution.”
Investors must understand the difference between capital distribution and income distribution. Income distribution refers to the increase in NAV, whereas capital distribution refers to the increase in the equalization reserve or the investor’s capital.
In other words, SEBI wants to highlight that your income is entirely derived from your investment capital. Therefore, IDCW is a more appropriate way to describe variances and encourage the transparency of mutual fund distributions. You will also get a clear understanding of mutual fund payouts.
Difference Between Dividend of Stocks and Mutual Funds:
Though mutual fund distributions appear to be identical to corporate payouts, there are significant variations between the two: –
1. Companies distribute dividends from their Profit After Tax (PAT) after setting aside a portion of the profit as Reserves and Surplus for the company’s potential future growth. The management chooses how much of the profits should go to shareholders in the form of dividends.
The cumulative profits of the program are used to pay mutual fund dividends. The AMC determines the dividend payout rate per unit. Whether a scheme pays dividends or not, all earnings belong to the investors and are recorded in the scheme’s Net Asset Value (NAV).
2. A company’s stock price may increase or decrease after the announcement of dividends.
After dividends are paid, a scheme’s Net Asset Value (NAV) will always decrease.
Growth or IDCW – Which is the Ideal Choice?
You can make a decision based on the following factors:
The growth Option allows for the scheme’s profits to be reinvested in the scheme. You can generate profit on profit if your investment tenures are long enough. This is called the power of compounding. It plays a big role in building wealth.
The profits generated by the scheme in IDCW may be transferred to you in whole or in part at the AMC’s decision. You lose the benefit of compounding.
The growth option is recommended if your investment goal is to increase capital or create wealth.
You can use IDCW if you want consistent cash flows from your investments. However, remember that the AMC has the final authority in distributing income. Mutual funds do not provide income guarantees.
Capital gains on growth option redemptions are liable for tax. When investing in equity funds, short-term capital gains (holding periods of less than a year) are taxed at a rate of 15%. (plus, applicable surcharge and cess).
Long-term capital gains in equity funds (investments held for more than 12 months) are tax-free up to Rs 100,000 and taxed at 10% (plus any surcharges and cess) after that.
Your gross taxable income is increased by income (dividends) received through IDCW, which is then taxed at the rate specified by your income tax slab.
IDCW has a significant tax disadvantage for investors with higher tax rates compared to the growth option.
Conclusion:
The change in terminology from Dividend to IDCW is an attempt by SEBI to correct misconceptions about dividends. To correct incorrect views of dividends, SEBI changed the word from “dividend” to “IDCW.” If you want consistent returns on your money, you can invest in IDCW.
Investors must evaluate their risk profile, investment horizon, and goals before investing in mutual funds via any of the options; choosing a dividend or a growth option depends on your needs.
When markets are at their peak, the dividend option performs best. The possibility of the fund releasing dividends increases as the NAV of the fund increases regularly.
Additionally, the dividend option can be suitable for you if you rely on your investments for a consistent source of income. Investors looking for a constant income source who are approaching or have reached retirement age may consider this.
However, consider the growth option if your goal is to accumulate wealth. Investors focused on wealth accumulation and with a long-term investing perspective may find the growth option ideal. It will benefit them in saving money for retirement.
Furthermore, choose the growth option if you have a steady income and do not require dividends.