Dividend vs Growth Mutual Fund: Understanding the Impact of Each Option

Impact of Dividend vs Growth Options in Mutual Funds

Investing in mutual funds offers a variety of options tailored to different financial goals and risk appetites. Among these, IDCW (Income Distribution cum Capital Withdrawal) and growth options stand out as popular choices for investors seeking returns in different forms. Understanding the nuances of IDCW vs growth and the IDCW meaning in mutual funds can help investors make informed decisions aligned with their financial objectives.

Dividends in Mutual Funds

As of April 1, 2021, the nomenclature of ‘dividend’ changed. Mutual funds no longer have a category referred to as ‘Dividends’. The term ‘dividend’ has been replaced with ‘distribution’. Additionally, the ‘dividend Plan’ of a mutual fund scheme has been rebranded as the IDCW.

The ‘dividend plan’ nomenclature has misled many mutual fund investors into thinking it is a bonus on top of the returns their scheme provides. This was quite misleading because when a mutual fund scheme pays dividends, it is essentially taking some of the money that already belonged to the investors and distributing it to them.

Impact of Dividend (IDCW) on Mutual Funds

Let’s understand the impact of IDCW on your mutual fund investment with an example. If you own 10,000 units in a mutual fund scheme with a NAV of Rs. 30, and the fund announces a dividend of Rs. 2 per unit, you will receive a dividend of Rs. 20,000 for your 10,000 units.

However, this amount does not represent additional income. The mutual fund scheme will deduct the ₹20,000 paid to you as a dividend from your investment. On the day the scheme initiates the transaction to pay out the dividend, the NAV of the scheme will decrease by ₹2, dropping from ₹30 to ₹28.

In simpler terms, the mutual fund scheme will pay you ₹20,000 as a dividend, causing your investment in that scheme to decrease from ₹3 lakhs to ₹2.8 lakhs.

Mutual fund schemes essentially redistribute a portion of your existing funds back to you in the form of dividends. This is precisely captured by SEBI’s newly coined term - IDCW.

Who Should Invest in IDCW Mutual Funds?

IDCW in mutual funds is suitable for investors who prefer regular income through periodic payouts. This option is ideal for individuals who rely on these funds to supplement their income, such as retirees or those seeking additional liquidity. The IDCW meaning involves distributing the fund's profits to investors in the form of dividends, offering a tangible return on investment. However, it is crucial for investors to understand that these payouts are not guaranteed and depend on the fund's performance and profits.

Growth Option in Mutual Funds

Growth options in mutual funds prioritise capital appreciation. Instead of receiving regular payouts, investors reinvest their earnings into the fund. This can lead to the compounding of returns over time, potentially resulting in significant wealth accumulation.

Suppose you have 1000 units of an equity fund at an NAV of ₹40. In one year, the NAV of the scheme increases to ₹50 under the growth option. You then sell the units, earning a sum of ₹50,000 — consequently, your profits from the investment amount to ₹10,000 (₹50,000 - ₹40,000).

Reinvesting earnings allows for compounding, where returns generate additional returns. Over the long term, this compounding effect can significantly boost the overall value of the investment.

Who Should Invest in Growth Mutual Funds?

Growth mutual funds are best suited for investors with a long-term horizon who are focused on capital appreciation. Unlike IDCW, the profits earned by the fund are reinvested, contributing to the compounded growth of the investment. This option is ideal for individuals who do not require immediate cash flow and are comfortable with potentially higher volatility in exchange for greater returns over time. Investors seeking to build wealth and achieve significant financial goals may find growth funds more aligned with their strategy.

Dividend (IDCW) and Growth Option - The Differences

The table below captures the differences between IDCW and growth options on several parameters -

IDCW Vs Growth – Illustrating the Difference

Consider two investors: one opts for IDCW and the other for growth in the same mutual fund. The IDCW investor receives regular payouts based on the fund's earnings, providing liquidity but potentially limiting capital growth. Meanwhile, the growth investor sees no immediate payouts, but the reinvested earnings contribute to the fund's overall value, potentially resulting in a larger corpus over the long term. This example illustrates the trade-off between immediate income and long-term wealth accumulation in the IDCW vs growth debate.

Tax implications - Dividend (IDCW) Vs Growth

Understanding the tax implications is crucial when considering what IDCW is in mutual fund investments. IDCW payouts are subject to taxation as per your income tax slab, which can reduce the net returns if you are in higher tax brackets. In contrast, growth mutual funds attract capital gains tax, with long-term gains generally taxed at a favourable rate compared to regular income. It is important for you as an investor to evaluate your tax liabilities and consider how the choice between IDCW and growth might impact your after-tax returns.

Choosing Between Dividends (IDCW) and Growth Options

The choice between dividends and growth options ultimately is based on your financial objectives, risk appetite, and investment horizon. Here are a few factors to consider when making this decision:

1. Income Needs: If you require regular income from your investments, dividends (IDCW) may be better. However, if you have other sources of income or a longer investment horizon, growth options may be more suitable.

2. Risk Appetite: Dividend-paying companies often have lower volatility, making them less risky. On the other hand, growth investments can be more volatile due to the nature of high-growth companies.

3. Tax Considerations: Investors in higher tax brackets may prefer growth options to defer taxes until they sell their shares, potentially benefiting from lower capital gains tax rates.

Can You Switch from the Growth Option to IDCW?

As an investor, you have the flexibility to switch between these options based on your changing financial needs. Switching from growth to IDCW can be beneficial for those who transition from a wealth accumulation phase to a phase where regular income becomes a priority. However, it is essential to consider any exit loads or tax implications associated with such a switch. Consulting with a financial advisor can aid in understanding the timing and consequences of making this transition effectively.

Summing it Up

Dividends (IDCW) and growth options in mutual funds both offer distinct advantages and considerations for investors. The IDCW meaning in mutual fund investments is centred on providing periodic income and stability, while growth options are designed for those seeking capital appreciation potential long-term gains. Deciding between IDCW vs growth therefore, requires a comprehensive understanding of your financial goals, income needs, and tax situation.