Individuals invest in mutual funds primarily for one of the two purposes: long-term capital gains or regular income in the form of dividends. This blog focuses on the dividend option. We will discuss what is IDCW in mutual funds, its overview, benefits, and risks.
What is IDCW in a mutual funds?
Before April 2021, you had to choose between the growth or dividend option when you invested in mutual funds. If an investor selected the dividend option, the mutual house paid the investor the dividend declared from time to time. If an investor selected the growth option, the AMC reinvested the dividend on behalf of the investor.
The scheme’s investment portfolio for the growth and dividend option is the same. However, the difference is with regards to how the scheme profits are utilized, whether for dividend payment to investors or reinvestment on their behalf.
In April 2021, SEBI changed the dividend terminology to Income Distribution cum Capital Withdrawal (IDCW). So the dividend option is now known as IDCW. When an investor chooses the IDCW option, the fund declares a dividend (income distribution) regularly from the scheme gains and pays it to the investors. Usually, the dividend is declared annually, but some schemes may declare it half-yearly, quarterly, or even monthly.
Now that we understand what is IDCW in mutual funds, let us understand SEBI’s rationale behind this move.
Why did SEBI do the renaming to IDCW?
Before we look at why SEBI changed the terminology, an investor needs to understand what is IDCW in mutual funds & that this is just a terminology change. It has no impact on the earlier functioning of the scheme, and it doesn’t impact the investors also. SEBI changed the terminology and asked AMCs to inform the investors about the change.
The major reason behind SEBI changing the dividend option to IDCW is to clear the misconception among investors. Many investors earlier thought that the dividend declared by the scheme is a bonus over and above the scheme returns. But, this is not the case.
Investors treated the dividend received from AMCs similarly to the dividend received from listed companies. They thought just like the company dividend; the mutual fund scheme dividend is also over and above their investments in shares of the company. It is crucial to understand what is IDCW in mutual funds.
SEBI wanted to put across the message that in the case of mutual fund dividends, they are declared and paid from the investors’ money itself. When the investor is opting for dividend payment, they are in turn withdrawing a part of their capital. This is capital withdrawal, hence the terminology Income Distribution cum Capital Withdrawal or IDCW.
What are the benefits and disadvantages of IDCW?
The benefit that an investor gets from the IDCW option is the regular cash flow in the form of distribution (dividend) as distributed by the mutual fund scheme from time to time.
However, there are some disadvantages of IDCW. Some of these include:
- Adverse impact on compounding
An investor needs to understand that a mutual fund scheme pays dividends from the investors’ surplus, which belongs to investors. Opting for the IDCW option is like withdrawing your own money. The net asset value (NAV) is adjusted downward with the dividend paid per unit when a mutual fund scheme declares a dividend. For example, if the scheme NAV is Rs. 20, and a dividend of Rs. 2 per unit is declared, the NAV will be adjusted to Rs. 18, and the Rs. 2 per unit will be paid as a dividend to the investors.
When the investor opts for the IDCW option, the scheme NAV will be reduced every time a dividend is paid. So, this will impact the compounding of returns. Investors who opt for the growth option, their dividend is reinvested, and they start earning returns on the reinvested dividend amount. So, they earn a profit on profit and benefit from the power of compounding. But, investors who opt for the IDCW will be deprived of the full power of compounding as they regularly withdraw the dividend amount.
The dividend received by the investor is taxed in the hands of the investor. The dividend is taxed as per the investor’s income tax bracket. So, if an investor is in the 30% tax bracket, their dividend will also be taxed at 30%, thus reducing their actual return.
- Tax Deducted at Source (TDS)
If the overall dividend amount exceeds Rs. 5,000, there will be a TDS deduction.
Choose a growth option to benefit from compounding
Now that you know what is IDCW in mutual funds when investing for long-term financial goals such as accumulating a corpus for a child’s higher education or own retirement, you should opt for the growth option instead of the IDCW option. It will ensure your dividends are reinvested and you benefit from the power of compounding in the long run.