Mutual fund ‘dividend’ is a misnomer. And tax-inefficient, too

While investors still equate the term ‘dividend’ in stocks to the ‘dividend’ received from mutual funds, the reality is quite different and the terminology can be misleading. From April 2021, the Securities and Exchange Board of India (Sebi) has changed the terminology from dividend to IDCW (income distribution cum withdrawal). This change makes it clear what fund houses do—they do not declare dividend, they simply distribute income to investors by reducing investors’ capital (capital withdrawal).

Thus, for a person investing in mutual funds, two options are available: the growth option and the IDCW option.

The growth option of investing in mutual funds is where the profit made by the scheme’s portfolio is automatically reinvested into the scheme and the investor’s investment simply grows in value.

In the IDCW option, the accumulated profit made by the scheme is distributed to the investors. On selecting the IDCW option, investors have two choices: payout or reinvestment. In the payout mode, the accumulated income is paid out to the investors, like how dividend is given to investors for their stock holding. In the reinvestment option, the income is reinvested into the scheme by purchase of additional units with the distributed amount. The purchased units are added back to the existing holding of investors.

So, while no income in any form is received in the growth option, under the IDCW option the investor receives income either in terms of direct transfer or additional units. Let’s understand the growth and IDCW options a bit more.

Regular income is not assured: An important factor that those opting for the IDCW option must keep in mind is that the decision to distribute income is that of the fund manager and is not set in stone. Mutual fund schemes are not obligated to distribute income and there is no specification on the payout rate or frequency of distribution. For investors who have chosen the IDCW option hoping to receive a steady flow of income, there is no guarantee that their requirement will be met.

Impact on net asset value (NAV) and returns: Be it the growth option or the IDCW option, all factors of the scheme, including the portfolio, are the same. The only difference is the distribution of the accumulated income and how the NAV is impacted by the distribution of the income.

In the IDCW option, be it reinvestment or payout, the NAV reduces once the income is distributed. This is similar to stocks, where the share price falls post dividend declaration. It is important to note that even though investors receive income, the value of the portfolio is reduced by an equal amount. Thus, contrary to what investors believe, they are not receiving any additional income or gain. In the growth option, the accumulated profits of the scheme are automatically reinvested into the scheme, resulting in the NAV of the scheme increasing.

Tax inefficiency of the IDCW option: “Taxation of dividend from mutual funds has undergone dramatic changes from 1 April 2020. Previously, the fund was paying dividend distribution tax (DDT) on the dividend declared; however, now the investor will be subject to tax as per his/her respective tax slab rate. Further, tax at 10% is also deductible at source (TDS) by the fund on such dividend, where the sum received is more than ₹5,000 per financial year,” explains G.R. Hari, chartered accountant and partner at Manohar Chowdhry & Associates.

“This has made it painful for investors who have opted for the IDCW option. Such investors have to pay tax as per their income tax slab rate on the income distributed to them from the mutual fund investment. In fact, even in the reinvestment option, the additional units purchased from the income distributed will be treated as dividend and taxed at the slab rate,” explains Hari.

In comparison, investors with mutual fund holding under the growth option are not liable to pay any tax until they make a profit at the time of redemption. Thus, investors find the IDCW option less tax-efficient compared to the growth option.