Let us understand growth, IDCW Reinvestment and Payout options and see which is a better choice for a retail investor
As a Mutual Fund investor, you have two options – The first is the Growth Option, while the second option is called the “Income Distribution cum Capital Withdrawal” option or IDCW option.
The IDCW was earlier known as the dividend plan, but SEBI has made it mandatory to rename the dividend plans of mutual funds into IDCW plans or the IDCW option.
With the Levi of long term capital gains tax or LTCG and the income from Dividend as taxable as per your tax slab, which option (aka growth or IDCW) is a better choice for retail investors in the long run?
Before choosing between the growth and IDCW option, let us understand all the tax components for investing in equities (stocks or equity mutual funds) for the longer term.
LTCG in Simple Terms
We have a new tax for LTCG. It stands for Long-Term Capital Gains.
Any investment in the equity market (stocks or equity mutual funds) for more than one year had no tax liability on returns before 31st January 2018 as they were classifieds as long-term capital gains.
From Feb 1st, 2018, we have a 10% tax on the returns for stocks held for a year or more.
The gains weren’t taxed until 31st Jan 2018. So any gains made till 31st Jan 2018 are still tax-free. So the tax calculation isn’t based on the purchase price. However, it is based on the price as of 31st Jan 2018 and profits after that.
Let us understand this with an example from my open portfolio. Any equity investment before 31st Jan 2017 was termed as long-term capital gains as of 31st Jan 2018. So the investment in Pidilite Industries was in September 2016.
So in September 2017, it became a long-term investment, and any gains were tax-free.
The purchase price was ₹720ish. On 31st Jan 2018, the price of the stock was ₹900ish.
So the LTCG calculation when I sell Pidilite Industry after March 2018 will be based on ₹900 and not on the purchase price of ₹720.
All the long-term gains are tax-free as of 31st Jan 2018, and tax is levied only on incremental increases after 31st Jan 2018.
The same calculation also applies to equity mutual funds where the returns till 31st Jan 2018 are tax-free.
On top of the above tax free amount, every fiscal one has an additional tax free LTCG income slab of ₹1Lacs.
So even if I book profits of up to 1L in the next fiscal for my long-term investment, I still don’t have to pay any LTCG tax.
So for the 1,000 units of Pidilite and for the sake of calculation in the next fiscal, i.e. from April 2018 to March 2019, if the price of Pidilite touches Rs.1000 and if I sell, I still don’t pay any LTCG because profits aren’t more than 1L assuming I don’t make any other profit as LTCG in the fiscal.
Tax on Dividends
The dividend received by any individual in a fiscal year is added to his overall income, and he has to pay the taxes based on his income slab.
So your income slab depends on whether you have opted for a new tax regime or are still on the old one.
I will not get into the details of the regime, but one should understand that the new tax regime can primarily benefit middle-class taxpayers. The old regime is a better option for high-income earners.
Further, the new income tax regime benefits people who make lower tax-saving investments. So anyone paying taxes without claiming tax deductions can benefit from paying a lower tax rate under the new tax regime.
If you want to get the complete details of the tax regime, I will suggest you look at this article on ClearTax.
Still, for calculation’s sake, let’s assume your income slab is such that you are paying a 10% tax equal to the LTCG tax. If the dividend income increases, your tax slabs can mean you pay more taxes.
Growth Vs IDCW for Re-Investment / Payout
We have understood the tax implications for both LTCG for booking profits in growth and dividend for IDCW.
Now let’s understand the three schemes for investments in each regular or direct plan. (Direct plans are recommended)
- Growth Option or No Dividend Option.
- The dividend is paid out to the investor.
- The dividend is reinvested in the same fund.
In the third option, as the dividend is not paid to the investor, it is often considered equivalent to the growth option, but there is a difference.
So let us understand each of the above options and see the difference between the dividend re-invested option with the growth option and which is a better choice for an investor.
The invested amount allocates the number of units to the investor based on the NAV value of each unit on the given date of investment.
If the NAV of a fund is ₹ ten and if investors invest ₹10,000. He will be allocated 1,000 units.
In the growth option, the number of units remains the same for the investor till the investor redeems them partially or fully.
Funds declare dividends from time to time. For example, some funds pay dividends quarterly, whereas others opt to pay yearly.
The amount of dividend declared by a fund is paid to the investor. So the same price per unit reduces the NAV for the fund.
It means if the NAV of the fund is ₹12 and if the fund declares the dividend of ₹1. The Nav of the fund for the following day will become ₹11 assuming there is no change in the net asset for that day. If there is a change in the net asset, the NAV is adjusted accordingly.
The amount of dividend declared by a fund is not paid to the investor but instead is used to purchase more units of the same fund.
Let us understand this with an example.
If the NAV of a fund was ₹ ten and if investors invested ₹10,000, he was allocated 1,000 units.
The NAV of the fund increased over time to ₹12. The mutual fund declares a dividend of ₹1. Let us assume the NAV of the fund the following day is ₹11.
The dividend of ₹1,000 was to be paid to the investor, but the option selected by the investor was dividend re-investment. As a result, the fund automatically purchases extra units of the fund for the investors.
So the number of units purchased by the fund for the investors is 90.90.
The total number of units of the investor has increased from 1,000 to 1,090.90, and they are being valued at ₹11.
Now, let us look at the above example as a table.
|IDCW Reinvestment||IDCW Payout||Growth|
|Fund Declares Dividend Of ₹1|
|Dividend Amount||₹1,000 (1,000 units * ₹1)||₹1,000 (1,000 units * ₹1)||NA|
|Dividend Paid Out||NA||₹1,000||NA|
|NAV After Dividend||₹11 (12 – 1)||₹11 (12 – 1)||₹12|
|Units issued for reinvestment||90.90 units (₹1,000/11)||NA||NA|
|Total No. Of Units Held||1090.90||1,000||1,000|
|Amount post dividend||₹11,999.9 (1090.90*11)||₹11,000||₹12,000|
The number of units multiplied by the NAV is the final amount.
- In the dividend payout option, the number of units remains the same as the growth option.
- In the dividend re-investment option, the final amount remains the same as the growth option.
If we only consider the final amount, the Dividend Re-Investment and Growth options have no difference.
However, the results will change once we consider the taxation part.
The Tax Impact On IDCW Reinvestment
The income tax rules have no relaxation if you reinvest the dividends in the same mutual fund scheme.
So, though you have re-invested the dividends, they are treated as if you received the dividend and then invested the same amount in the fund again. So, even if you are not receiving the money in your bank account, you need to pay the tax on the dividends received.
Further, the mutual fund must deduct a 10% TDS if the overall dividend amount in the full fiscal year exceeds ₹5,000.
So the reinvested amount is lower due to the TDS. Consequently, the value of the final investments in the fund will reduce as well.
IDCW Re-Investment Or Growth?
I was a fan of the Dividend option for saving tax pre-2018. However, now after LTCG and changes in the taxation for dividends, I always opt for the growth option.
The IDCW Reinvestment and Growth plans make sure the amount you have invested keeps compounding for better returns.
However, Growth Plan is more tax-efficient than the Dividend Reinvestment or IDCW Reinvestment. Further, with LTCG, a tax-free return of 1L makes it an even better choice.
So opt for the growth option if you want to let the compound, but if you need regular income, go with IDCW payout. However, IDCW reinvestment isn’t a good choice under any circumstance.