An annual mutual fund ritual

Previously, in this column, we discussed the cost of switching from a regular plan to a direct plan for your mutual fund (MF) investments. To complete the discussion, we look at the growth and income distribution cum capital withdrawal (IDCW) options offered by fund houses.

Reinvesting cashflows

The IDCW option was earlier called the dividend option. This option allows a MF the discretion to return a portion of the portfolio to unitholders. The portfolio, determined as the net asset value (NAV) per unit, consists of unitholders’ capital invested, unrealised gains on stocks held, realised gains on stocks just sold and held as cash and dividend income earned on the stocks in the portfolio.

Suppose you invest in an equity fund to achieve a goal. You must earn a pre-determined compounded annual return on your investment to accumulate the amount required to achieve the goal. So, it is better to let investment in the fund compound annually. If you choose the IDCW option, you must find avenues to reinvest the cash flows received from the MF. The point is MF managers are better placed than us to find attractive avenues to reinvest. This makes the growth option better.

You must also consider the tax incidence of growth and IDCW options. Tax laws continually change. The principle is, however, simple. You pay taxes on growth option only when you sell your units. Also, given that you are investing to achieve your life goal, you are likely to hold the investment for more than one year. Long-term capital gains tax on equity is typically lower than your marginal tax rate. Therefore, if cash flows from IDCW continue to be taxed at your marginal tax rate, the growth option is tax efficient. But what if tax laws change and IDCW is tax exempt, as the dividend option was earlier? Then, IDCW would be efficient for taxable investors. But you must reinvest the cash flows. So, you could consider the IDCW reinvestment option, if available then.

Conclusion

Under the current tax laws, the direct plan growth option of an equity fund is optimal for goal-based investments. You must typically rebalance your mutual fund investments annually to reduce the risk of losing unrealised gains. This requires you to sell some units and take profits greater than your annual expected return in the fund, and reinvest the resultant cash flows into bank deposits.

(The author offers training programmes for individuals to manage their personal investments)