What is an IDCW in mutual funds?

IDCW plans, or Income Distribution cum Capital Withdrawal plans, are a type of mutual fund where the fund distributes dividends to investors. These payouts are derived from the fund's profits or a portion of the invested corpus.

In this article, we will explore how IDCW in mutual funds work, their taxation rules, common misconceptions, and whether they are suitable for long-term investors. Let's jump right in!

How does an IDCW in mutual funds work?

IDCW plans function as a payout option offered by mutual funds. Here's how they operate:

• Announcement of dividends: When a fund house opts for a dividend payout, a specific dividend per unit of the mutual fund is announced.
  
• Portion of corpus returned: This payout isn't an additional profit but a portion of your invested corpus being distributed back to you.

Let's illustrate this with an example:

Imagine you own 1,000 units of a mutual fund priced at Rs 200 each. The fund house announces a dividend payout of Rs 2 per unit. You would receive a dividend of:

1,000 units x Rs 2 per unit = Rs 2,000

However, this payout reduces the Net Asset Value (NAV) of your fund proportionally. In this case, the NAV would drop by the same amount, bringing it down to Rs 198 per unit. Consequently, your overall corpus decreases by the dividend amount.

Suggested read: IDCW mutual funds: Should you invest in a 'dividend' option?

Taxation of IDCW plans

For any long-term investor, taxation is a key consideration when choosing a mutual fund:

• Taxation at slab rates: Dividends received from an IDCW in mutual funds are taxed at your individual income tax slab rate. This can significantly impact your post-tax returns, especially if you fall into a higher tax bracket.
  
• No tax benefits: Unlike growth plans that allow you to defer taxes until redemption, IDCW plans impose a tax burden as soon as the dividend is received.

Suggested read: Mutual fund taxation: Here's how it works

What are the common misconceptions about IDCW plans?

Despite their prevalence among mutual fund investors, these plans are quite misunderstood. We'll tackle some of these myths:

1. Every dividend payout is a result of the fund's portfolio of stocks paying out dividends
While the dividends may be paid out from stocks announcing dividends, it can also be paid from gains generated by selling the underlying stocks.

2. The dividends you receive are over and above the capital gains
Dividends received aren't additional income. Instead, they are a portion of the gains received by selling stocks, which means that part of your existing capital is being paid back to you.

3. Mutual funds regularly book profits to pay dividends
This is not true. The payment of dividends is at the discretion of the fund manager. So, the fund house can decide at any arbitrary time to offer a dividend payout.

Suggested read: Dividends were never dividends

Should you invest in them?

Our advice is to avoid these plans. One of the primary issues is that they do not reinvest dividends. Instead, the dividends are paid out, which reduces the investment's Net Asset Value (NAV) and limits the potential for compounding.

Additionally, dividends from an IDCW, in mutual funds, get taxed at the investor's slab rate, which can significantly erode returns. This makes them an inefficient choice for any investor, even those seeking regular payouts, as the tax burden further reduces the effective return on investment.

Lastly, dividends are paid out at any arbitrary date. This makes it difficult to create a regular income stream.

Suggested read: Growth vs IDCW mutual fund: Which option suits you best?

Conclusion: How to make the right choice

While an IDCW in mutual funds may seem like a viable option for generating a retirement income or creating a passive income stream, the reality is quite different. The dividends are taxed at the slab rate; if you are in the higher tax brackets, you are left with very little. Also, your dividends are taxed the moment you receive them.

Furthermore, the fund house determines the date of transferring dividends. This makes it tricky to create a regular income stream.

It is much wiser to opt for a growth plan and transfer the required proceeds to your account through an SWP (Systematic Withdrawal Plan). That way, you can ensure that you'll get regular income whenever you require it instead of waiting for the fund house to release your funds.

As discussed, an IDCW in mutual funds pays dividends from your existing capital. This makes the returns much lower for these plans than those of growth plans. This is because growth plans reinvest those dividends, allowing you to benefit from the power of compounding. That's why we advise you to opt for growth plans for any fund.

If you're looking for the right mutual fund to meet your long-term investment goals, Value Research Fund Advisor is here to help. Our platform is designed to guide investors toward achieving their objectives through tailored fund recommendations.

With the help of expert advice, you can grow your wealth strategically and take control of your financial journey. Let us empower you to make informed decisions and become a confident investor.

Also read: Mutual fund dividend plans are a harmful option

This article was originally published on January 15, 2025.