For investors, profits are the most alluring aspect when considering investments. When companies make profits, they often reward their investors and shareholders by distributing a portion of those earnings as “Dividends.”
As a shareholder, you are essentially a partial owner of the company. So when companies make profits, they distribute them amongst their owners. This income is apart from the capital appreciation on your investment.
But surprisingly, many investors used to believe that mutual funds also distribute dividends similar to stocks, leading to a common misconception. To give you some context, mutual funds are broadly divided into two distribution options: Growth and Dividend options.
Under the Dividend options, however, the fund schemes didn’t offer additional returns like stocks. Instead, these dividends were deducted from the investors’ overall investments and paid out as “Dividends.”
To clarify the situation, in 2021, SEBI took action by renaming the dividend option to the IDCW option. It’s essential to note that this change only affected the option’s name, not its functioning.
In this article, we aim to provide a comprehensive understanding of what an IDCW option in a mutual fund entails and how it operates, as well as debunk the myths around it.
What is the IDCW option in mutual funds?
IDCW stands for Income distribution cum capital withdrawal.
Under this option, a part or percentage of your mutual fund investments will be distributed to your bank account. This distribution includes the income earned by the underlying security (dividend or interest) and the appreciated capital of the investment.
The frequency of the payout can be daily, weekly, monthly or annually and varies according to the fund invested. These options are popular among investors who are looking for regular income along with capital appreciation for their investments.
How does the IDCW option work?
To understand the working of the IDCW, let’s suppose you own 8,000 units of a fund worth ₹2,00,000 with a current NAV of ₹25 in a fund with IDCW option. The fund announces a distribution of ₹2 for the period. However, the fund earned ₹5 in the same period.
| Working of the IDCW option | |
| Number of units allotted | 8,000 |
| Current NAV | ₹25 |
| Current investment value | ₹2,00,000 |
| Income through Dividend / Interest | |
| Income (₹5 x 8,000) | ₹40,000 |
| NAV after income addition | ₹30 |
| Investment value after income addition | ₹2,40,000 |
| Distribution / Payout | |
| Payout (₹2 x 8,000) | ₹16,000 |
| NAV after payout | ₹28 |
| Investment value after payout | ₹2,24,000 |
As in the above case, the IDCW option distributes the income ₹16,000 out of ₹2,40,000, which is already part of your investment. In other words, the IDCW options clearly aim to distribute your investment as income, which was already included in your investment value.
In the above case, there was an addition of ₹5 to the investment value, which was greater than the payout value, ₹2. So, the payout was adjusted to the income, and no capital withdrawal was executed.
However, in some cases, the difference between payout and income can be zero or negative. Then, the distributed payout will be withdrawn from your invested capital.
For example, if in the above, no additional income was earned during the period, and the fund availed a payout of ₹2. Then, the payout will be adjusted with your capital/investment.
| Working of the IDCW option | |
| Number of units allotted | 8,000 |
| Current NAV | ₹25 |
| Current investment value | ₹2,00,000 |
| Distribution / Payout | |
| Payout (₹2 x 8,000) | ₹16,000 |
| NAV after payout (₹25-₹2) | ₹23 |
| Investment value after payout | ₹1,86,000 |
To avoid this confusion about capital withdrawal/distribution, SEBI renamed the dividend option. Hence, goes the name of the IDCW option, “Income Distribution cum Capital Withdrawal.”
IDCW options, though, serve the same purpose as dividend options. However, the terminology has created confusion among the investors. Some of the myths that need to be clarified are:
● Myth 1: Mutual fund does not pay dividends, like stocks
Some investors believe that when mutual funds pay dividends, the payments are solely sourced from the dividends or the interest received from the underlying securities in the scheme portfolio. However, the reality is that when mutual fund schemes pay dividends, it may include a combination of dividends received from the underlying stocks as well as profits generated by selling the stocks in the portfolio.
● Myth 2: Mutual fund dividends are only an extra income
Another misconception is that dividends received from mutual funds are extra income on top of the capital appreciation. In actuality, dividends received from mutual funds are not additional income over and above the profits made on redemption.
Instead, mutual fund dividends are a form of capital appreciation that is essentially paid from the investor’s own capital. As a result, the Net Asset Value (NAV) of the dividend scheme decreases to the extent of dividends paid to investors.
● Myth 3: IDCW and Growth are different options, they are not two different funds
Some investors may believe that dividend option mutual fund schemes book profits regularly to pay dividends to investors. However, it’s important to understand that the underlying mutual fund scheme portfolio remains the same for all options, whether it’s the growth option or the dividend option (IDCW).
Things to consider before opting for an IDCW option
Before investing in an IDCW option, investors should consider three important aspects of a mutual fund investment:
IDCW is ideal for investors seeking regular income from their investments, making it a favourable option for retired individuals who require consistent cash flows. While IDCW payouts may not be substantial, they still hold importance and should not be overlooked, especially for investors relying on a steady income. Investors aiming for significant long-term returns should consider the growth option, as it focuses on capital appreciation rather than regular income.
Investors with a moderate risk tolerance often prefer IDCW in mutual funds as it offers relatively stable returns, even during bear market phases when dividends can provide some income. However, it should be noted that the income distribution through mutual funds is at the sole discretion of fund managers. It is subject to the performance of the underlying companies and market movements, and there is no guaranteed IDCW payout in mutual funds.
IDCW income is added to the investor’s taxable income and is subject to normal tax slab rates. Additionally, a TDS (Tax Deducted at Source) of 10% is applicable if the total payout exceeds INR 5000. So, if you lie in the 25% tax slab, then you may lose around ¼ of the income you receive. However, the growth option can be more tax-efficient in comparison to IDCW options, as it does not offer a regular payout.
Read our article about IDCW vs Growth to learn more about the tax and returns between IDCW and Growth.
IDCW options may not suit most investors due to the lack of control over the timing and amount of dividend payouts, which are decided by the mutual fund. This option is also tax-inefficient, particularly for those in higher tax brackets, as dividends are added to taxable income and taxed at normal rates.
The growth option is generally more advantageous, allowing for capital appreciation and income generation through planned withdrawals, such as a Systematic Withdrawal Plan (SWP), which offers better control and tax efficiency. Consulting a financial advisor is recommended to determine if IDCW aligns with an individual’s financial goals and needs.
IDCW option in mutual funds: Frequently Asked Questions
What is the full form of IDCW?
The full form of IDCW is “Income Distribution cum Capital Withdrawal.”
When do you receive the payout from IDCW?
The payout from IDCW depends on the fund manager’s decision, and investors do not have control over the timing. The payout depends on the fund’s performance and available profits.
What is the IDCW reinvestment option?
The IDCW reinvestment option allows investors to automatically reinvest the dividends received from the mutual fund back into the same scheme. Instead of receiving the dividends in cash, the amount is used to purchase more units of the fund, thus enhancing the investor’s holdings.
Do all mutual funds offer IDCW options?
No, not all mutual funds offer IDCW options. Some mutual funds provide both growth and IDCW options, while others may only offer the growth option. The availability of IDCW options depends on the specific mutual fund scheme.
Which option is better, growth or IDCW?
The choice between the growth and IDCW options depends on the investor’s financial goals and preferences:
● Growth Option: The growth option is more suitable for investors looking for long-term capital appreciation. In this option, the fund does not pay regular dividends, and instead, the profits are reinvested in the scheme, potentially leading to higher overall returns.
● IDCW Option: The IDCW option is more appropriate for investors seeking regular income from their investments. It is commonly preferred by retirees or those looking for periodic payouts. However, the income is generated from the investor’s capital and can result in a reduced NAV over time.