IDCW vs Growth Option: Which One Should You Opt for?

September 17, 2024

Investing in mutual funds provides numerous options to suit the varying goals of investors. When selecting a mutual fund, an important decision revolves around choosing between two commonly offered investment plans:

• IDCW (Income Distribution cum Capital Withdrawal)
• Growth Option

Both choices are integral to mutual fund investments and have a significant impact on how an investor’s earnings are structured and taxed. This article delves into the details of IDCW and Growth options, explaining their definitions, differences, pros, cons, and suitability based on various investment goals.

What Are IDCW and Growth Options in Mutual Fund Investing?

Before comparing these two options, it is essential to understand what each represents.

1. IDCW (Income Distribution cum Capital Withdrawal) Option:

In April 2021, the nomenclature of ‘Dividend’ was changed by the Securities and Exchange Board Of India (SEBI). What used to be called ‘Dividend’ is now referred to as ‘Distribution’. Additionally, the ‘Dividend Plan’ of a mutual fund scheme is now called the ‘Income Distribution cum Capital Withdrawal Plan’ or IDCW Plan.

SEBI has also changed the names of dividend reinvestment options and dividend transfer plans, i.e., reinvestment of income distribution, transfer of income distribution, and capital withdrawal. As per SEBI regulations, fund houses must rename the three dividend plans and communicate to their investors that a portion of their capital can be distributed as dividends.

[Read: All You Need to Know About IDCW Option in Mutual Funds]

IDCW, previously known as the Dividend Option, refers to the option in which a mutual fund periodically distributes profits to investors in the form of payouts. These payouts are distributed from the profits generated by the fund and may be declared at the discretion of the fund manager, depending on the performance of the underlying assets.

Key Features of IDCW:

• Regular Income: Under IDCW, investors receive regular payouts in the form of income distribution.
• Payout Frequency: The frequency of payouts can vary (monthly, quarterly, half-yearly, or annually) and depends on the fund’s income generation.
• Source of Income: The payouts are not solely from profits but may also include a part of the investor’s invested capital.
• Tax Treatment: The income distribution is taxed according to the applicable tax slab of the investor, as it is treated as income from other sources.

2. Growth Option:

In the Growth Option, no dividends or payouts are made to investors. Instead, all the profits the mutual fund earns are reinvested into the scheme itself, allowing the net asset value (NAV) to grow over time. The focus here is on capital appreciation rather than immediate income.

Key Features of the Growth Option:

• Capital Growth: The entire profit generated is reinvested in the scheme, leading to a higher NAV over time.
• No Regular Payouts: Investors do not receive regular income; instead, they benefit from the compounding effect of reinvested earnings.
• Ideal for Long-term Investors: This option suits long-term investors who do not need periodic income and aim for wealth accumulation.
• Tax Treatment: The gains are taxed only when the investor redeems the units. Taxation is based on capital gains (short-term or long-term) depending on the holding period.

Detailed Comparison Between IDCW and Growth Options

Choosing between the IDCW and Growth options can be confusing for many investors. Let’s break down the differences across various parameters to make it easier to understand.

1. Nature of Returns

IDCW Option: In this option, the mutual fund distributes a portion of the profits as dividends to investors. These payouts provide a steady income, making it appealing to investors who prefer liquidity or require regular income to meet financial obligations. The NAV of the mutual fund decreases each time a payout is made, reflecting the distribution of earnings.

Growth Option: Here, all profits are reinvested, leading to capital appreciation over time. Investors do not receive any payouts during the investment period. The returns are visible in the form of an increasing NAV, which reflects the compounding of reinvested profits.

2. Tax Implications

In the recent Modi 3.0 budget presented on July 23, 2024, Finance Minister Nirmala Sitharaman introduced significant simplifications and rationalisations to the capital gains tax structure. The Short-Term Capital Gains (STCG) tax on certain specified financial assets, such as stocks and equity mutual funds, has been increased to 20%, up from the previous 15%. Meanwhile, the Long-Term Capital Gains (LTCG) tax on both financial and non-financial assets is proposed to be set at 12.5%, replacing the earlier 10% rate.

[Read: The Changes in Capital Gain Tax Done by Modi 3.0 Budget 2024-25 You Need to Know]

IDCW Option: The payouts under IDCW are taxable in the hands of the investor. The amount received is considered income and is added to the investor’s total taxable income. This is especially important for investors in higher tax slabs, as it can result in a higher tax liability.

Growth Option: In the Growth Option, taxation comes into play only when the investor redeems the units. If the holding period is less than one year, the gains are treated as short-term capital gains (STCG) and taxed at 20%. For a holding period exceeding one year, the gains are treated as long-term capital gains (LTCG) and taxed at 12.5% on gains exceeding Rs 1 lakh in a financial year.

3. Suitability Based on Investment Goals

IDCW Option: This option is more suited to investors who seek regular income from their investments. Retirees or individuals who need supplementary income may find IDCW a viable option. However, it is not ideal for wealth accumulation over the long term, as the NAV falls with each payout, reducing the scope for compounding.

Growth Option: Investors with a long-term horizon who do not require immediate cash flow but aim for capital growth should opt for the Growth Option. By reinvesting the profits, the power of compounding works in favour of the investor, leading to wealth creation over time.

4. Impact on NAV

IDCW Option: Whenever a payout is made, the NAV of the mutual fund decreases. This happens because a portion of the fund’s assets is distributed to investors, leaving a reduced pool of assets in the fund. The NAV fluctuates based on the frequency and size of the payouts.

Growth Option: The NAV in the Growth Option continuously rises, provided the fund performs well, as all the profits are reinvested into the scheme. The NAV reflects the compounded growth of the fund’s assets, giving a clearer picture of the fund’s performance over time.

Is It Possible to Switch from the IDCW Option to the Growth Option or Vice Versa?

In the context of mutual fund investments, switching your investments from one option to another within the same scheme is considered a sale (redemption).

You can switch from the IDCW plan to the Growth Plan or vice versa, but doing so will be seen as buying the other plan and redeeming the first. Therefore, if there are any exit loads, they will be assessed together with any tax repercussions. As a result, depending on how long you stay invested, the switch may be subject to exit load and capital gains tax.

Therefore, before switching from one plan to another, make sure you evaluate the overall benefit of the same.

[Read: How You Can Use a Mutual Fund Screener to Choose Mutual Funds]

IDCW vs Growth: Which One Should You Choose?

Deciding between IDCW and Growth options depends on factors such as your financial goals, investment horizon, and tax implications. Let’s consider some common scenarios to help you determine which option may be better suited to your needs.

1. Investors Seeking Regular Income:

If you need periodic income from your investments, the IDCW option may suit you. For example, retirees or individuals who depend on investment income to meet regular expenses would benefit from the regular payouts offered by mutual funds under the IDCW plan. However, it’s important to remember that these payouts are not guaranteed, as they depend on the fund’s performance.

2. Investors Focused on Long-term Wealth Accumulation:

If your goal is to grow your wealth over time and you don’t need regular income, the Growth option is ideal. It leverages the power of compounding, allowing your investment to grow exponentially over the long term. Young investors or those with a long investment horizon often prefer this option as it maximises the potential for higher returns.

3. Tax Efficiency Consideration:

Taxation is a significant factor when choosing between IDCW and Growth options. The IDCW Option can result in a higher tax burden, especially for individuals in higher tax brackets, as the income is taxable at the investor’s applicable tax slab rate. In contrast, the Growth Option provides a tax advantage as capital gains are taxed at a lower rate and only at the time of redemption.

4. Market Volatility:

During periods of market volatility, investors may prefer to remain invested for the long term to take advantage of potential market rebounds. The Growth option is better suited for such scenarios, as it focuses on capital appreciation over time. IDCW may not be ideal in volatile markets, as payouts could be lower or infrequent during periods of underperformance.

5. Risk Appetite:

If you are a conservative investor with a low-risk tolerance, the IDCW option may appeal to you due to the regular payouts, which provide a psychological cushion. However, if you have a higher risk tolerance and are willing to forego immediate payouts for long-term gains, the Growth option aligns with your goals.

Case Study: IDCW vs Growth Option

Let’s consider an example to see how the two options perform over time.

Scenario 1: IDCW Option

An investor invests Rs 1,00,000 in a mutual fund with the IDCW option. Over the next five years, the fund pays dividends of Rs 8,000 each year. After five years, the investor received a total of Rs 40,000 in payouts, but the NAV of the fund decreased due to the payout. The capital growth is limited since the profits have been distributed regularly.

Scenario 2: Growth Option

An investor invests Rs 1,00,000 in the same mutual fund but opts for the Growth option. Over five years, the NAV grew due to the reinvestment of profits, and the value of the investment appreciated to Rs 1,60,000. The investor benefits from capital appreciation and the power of compounding, although no payouts were received during the investment period.

In this example, the Growth Option results in higher wealth accumulation compared to IDCW, highlighting the importance of aligning your choice with your financial goals.

In conclusion, the choice between IDCW and Growth option depends largely on your financial goals, income requirements, tax considerations, and investment horizon. Ultimately, aligning your investment choice with your financial goals and understanding the nuances of each option will help you make an informed decision.

This article first appeared on PersonalFN here