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

The short answer is no. Even if you are looking for regular income, the 'dividend' option of a mutual fund may not benefit you.

Before we list the reasons, let's first understand the dividend option.

What is dividend option?
Every mutual fund has two options:

• Growth option
• Income distribution cum capital withdrawal (IDCW), also known as dividend option

In 'growth' mutual funds, your gains are reinvested, allowing you to create wealth at a faster pace.

IDCW, meanwhile, 'distributes' money from time to time. Let's assume you buy 1,000 units of a mutual fund. In a few months, you receive Rs 2 as 'capital distribution' per every unit, which is Rs 2,000.

While it sounds good on paper and you receive additional money, the reality is that this amount is subtracted from your investment. That's right, the money you receive is from your original investment itself! This is why mutual funds with dividend options had to be renamed 'income distribution cum capital withdrawal (IDCW)' to avoid confusing investors.

Now that you know what IDCW is, let's look at its other drawbacks.

The so-called dividends are paid at the discretion of the fund house
You have no control over when you receive the money. The fund house decides when they want to distribute any amount. Hence, it's not a reliable income-generator. Those seeking regular income should look somewhere else.

You lose out on the power of compounding
Since the fund house distributes the gains, your investment is untouched by the magic of compounding.

Put simply, compounding can multiply your money. The longer you stay invested, the faster your money can grow.

There's a reason why Benjamin Franklin, one of the United States' founding fathers, once likened compounding with a "stone that will turn all your lead into gold". Know how compounding can be a massive wealth-creator.

IDCW fails on the tax front too
Your income from the IDCW plan gets added to the total annual income and then taxed as per your slab rates. So, if you are in the highest tax bracket, you are liable to pay a 30 per cent tax.

What's surprising is that 13 per cent of total assets in the mutual fund industry are still invested in the IDCW option (as of December 2022). Even though this option fails at multiple levels, there needs to be more awareness about it.

But now that you know, it's best to steer clear of an IDCW option while starting a mutual fund investment.

What you should do
'Growth' mutual funds are an ideal investment option. They allow compounding to grow your wealth rapidly; they are also much better from a taxation standpoint. If you are looking for the best growth funds in the market, you can take a look at our 'Analysts' Choice' list.

And for those looking for a regular income, you can go through these options:

• Fixed deposits
• Senior Citizen Savings Scheme (SCSS)
• SWP (we recommend this option)

Please remember
Only those without a regular source of income should look at these investments. Ideally, retirees without pension or with insufficient pension should look at these three options.

Suggested read: Do interest paying funds affect your capital?