Should You Prefer Growth Option or Dividend Option in Mutual Funds?

Indian mutual fund schemes usually offer a growth option and a dividend option. Since 1 April 2021, SEBI has required the dividend option to be called “Income Distribution cum Capital Withdrawal” (IDCW), to make clear that a payout can include part of your own capital. Many schemes also offer an IDCW reinvestment option.

This leaves investors with an important question: should they choose the growth option or the dividend option when investing in a mutual fund?

The answer lies in a variety of factors such as what these two terms mean, and how they differ from one another. Before making a selection, here are five key variables that can be used to decide which is more suitable. If you would like help understanding these options, our mutual fund team can explain them.

The dividend earned never gets reinvested

There is a basic argument against dividend plans because you just receive the dividend and then spend it. Usually, you are quite satisfied with the intermediate flow and intend to use it for some pending purchase. You rarely reinvest the dividends. When a fund declares a dividend, it is paid out of its NAV. As a result, the NAV of the dividend plan will be reduced to the extent of the dividend.

Neither dividend nor growth plans have a different wealth effect. Since the dividend plan has taken Rs.4 out for dividend, its NAV is Rs.4 lower than the growth plan. You lose out on wealth creation if the Rs.4 taken out as dividend is not reinvested.

Growth option is more compatible with long term planning

This point succeeds the previous one. Strategizing for long term goals like retirement or your child’s education necessitates taking advantage of compounding. To do that, returns need to be consistently reinvested in the fund.

Settling for a dividend plan instead will significantly reduce wealth creation as dividends would consume most of the returns. Considerably, a growth option serves as an automatic wealth compounder and is particularly effective for compounding wealth in the long run.

To talk through which option suits your goals, contact our mutual fund team.

Tax on IDCW payouts compared with the growth option

Dividend distribution tax (DDT) was abolished from 1 April 2020. Since then, IDCW payouts are added to your income and taxed at your income-tax slab rate in the year you receive them, and the fund deducts TDS of 10% if your payouts from it exceed ₹10,000 in a financial year.

With the growth option, you pay tax only when you redeem, as capital gains. For equity-oriented funds, gains on units held for more than 12 months are taxed at 12.5% on gains above ₹1.25 lakh in a financial year, and gains on units held for 12 months or less at 20%. For many investors, especially in higher tax slabs, this makes the growth option more tax-efficient.

Growth and IDCW options in debt funds

In debt funds, IDCW payouts are also taxed at your slab rate each year that you receive them.

Under the growth option, gains on debt fund units bought on or after 1 April 2023 are also taxed at your slab rate, whatever the holding period, and indexation no longer applies. The difference is timing: with the growth option, you pay tax only when you redeem.

Whichever option you choose, it helps to understand how it works. Growth option reinvests your earnings, compounding your investment over time.

If you need regular income, then prefer SWPs

A growth plan may not offer regular income, which can be especially challenging for retired persons who rely on their debt fund portfolio to meet regular expenses. Fortunately, there is a solution. A Systematic Withdrawal Plan (SWP) allows one to withdraw both capital and returns each month.

This makes taxes more efficient as well, as only the return portion is subject to capital gains tax. Thus, this option offers a regular income while keeping taxes low. In general, growth options are better. However, if regular income is important to you, you might want to consider a SWP.

Also Read: How to regularly review your SIP allocation against your goals