Growth vs Income Distribution cum Capital Withdrawal (Reinvestment): Which Is Better?
When investing in mutual funds, investors can invest under different options, such as growth option, payout of income distribution-cum-capital withdrawal option, income distribution-cum-capital withdrawal reinvestment option, etc. Each of these different options carries its respective pros and cons. This article aims to discuss each of these three options briefly to help the investors decide on choosing amongst these three options:
Under the growth option, profits realised from the investment portfolio are reinvested within the mutual fund scheme. As such, the retained and reinvested profits result in appreciation in the fund NAV. Accordingly, the returns from the growth option can be measured through the appreciation in the NAV of the mutual fund schemes.
Payout of income distribution-cum-capital withdrawal (IDCW) option
If the investor has invested in IDCW, the mutual funds may distribute income to the unitholders based on the profits realised by the fund. As such, investors may measure the returns through the income received and the capital appreciation in the NAV (Net Asset Value) of the fund. However, such cash flows may not be recurring income, as the payout is contingent upon several factors, inter alia including available distributable surplus, realised profits, etc. However, if one requires regular cash flows from their mutual fund investments, one may consider opting for a Systematic Withdrawal Plan (SWP). Under SWP, the investments are redeemed at periodic intervals leading to regular cash flows to the investor.
Reinvestment of Income Distribution cum Capital Withdrawal (IDCW (Reinvestment))
Under this option, the income distributed by the mutual fund is reinvested into the scheme itself. Fresh mutual fund units are purchased at the prevailing NAV with the IDCW (Reinvestment) amount. As such, the investors may measure the returns through the appreciation in NAV compared with the weighted average cost of the mutual fund units whether purchased through initial investment or reinvestment of Income Distribution cum Capital Withdrawal.
The growth and IDCW (Reinvestment) options may seem the same optically, as the profits and income from mutual fund schemes are reinvested in the fund itself. However, there are some differences between these options leading to different tax incidences for the investors, as discussed below:
Different Tax Rates for Income Distribution and Capital Gains
When one invests in the growth option, the profits and appreciation in the fund value are reflected through an increase in the Net Asset Value (NAV) of the fund, leading to an overall increase in the portfolio valuation. Such gains are taxable as Capital Gains at specified rates when the investor redeems the mutual fund units.
In contrast, the income from the IDCW (Reinvestment) option may be taxed as income distribution and capital gains. While the capital gains are taxable in the same manner as the growth option, the income distributed under the option is taxed at the tax rates applicable to the investor leading to lower tax efficiency.
Further, the holding period for units invested in the IDCW (Reinvestment) option is considered from each investment date. As such, the holding period for the original units will be longer, while the same for fresh units purchased through dividend reinvestment will be lesser. In case the units accumulated through IDCW (Reinvestment) are not held for a prescribed period to qualify as Long-Term (12 months in case of equity-oriented mutual funds and 36 months in case of other than equity-oriented funds), the realised capital gains may get classified as Short-Term Capital Gains (STCG). As per the current tax laws, the tax rates for STCG are relatively higher when compared with tax rates for Long Term Capital Gains (LTCG). The current tax rates for equity funds are 15% (plus applicable cess and surcharge) for STCG and 10% (plus applicable cess and surcharge) for LTCG after an exemption of Rs. 1 lakh every year for equity shares and equity funds in aggregate. Similarly, the tax rates for funds other than equity-oriented funds are slab rates as applicable to the investor for STCG and 20% (plus applicable cess and surcharge) post indexation benefit for LTCG.
Point of Taxation
The gains from growth options are taxed at the redemption of mutual fund units. The investor needs to pay taxes only when profits have been realised.
In contrast, under the IDCW (Reinvestment) option, the reinvested income into the scheme is taxed as per the investor’s applicable tax bracket. While the investor does not receive any cash flows due to IDCW (Reinvestment), they must pay taxes on such income.
Capital gains are not subject to TDS deduction for resident Indians. There is no TDS incidence from the returns generated under the Growth option.
In contrast, income distribution is subject to TDS at the rate of 10% if the distributed income exceeds Rs. 5,000 in a year. This may impact the growth in the long run as the TDS amount does not get reinvested into the scheme. As such, the investors cannot reap the benefits of compounding to that extent.
Due to the above tax differences, investors in the growth option may be better off than those under the IDCW (Reinvestment) option.
Note: The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the investment date.