Investors invest with the motive of retaining the value of their funds and seeking them to grow by managing inflation. As a result, people often choose to buy stock market instruments of potential investable companies that pay dividends and value over the long term. However, these instruments are extremely prone to market volatility.
Mutual funds, on the other hand, collect the investor’s money and invest in the schemes as desired by the investor. It indirectly provides benefits of potential returns and seeks to protect them from market risk by diversification in the pool. Such benefits have increased the popularity of mutual funds in India. As of June 2024, average assets under management (AAUM) have reached the mark of ₹61.3 Trillion.
People are keen to invest and learn more about mutual funds.
However, there is usually a doubt – Do equity mutual funds pay dividends like regular equity instruments? Well, we have a detailed answer to this question!
Read this article to understand how mutual funds pay dividends, and what are dividend options, dividend yield funds, their examples and taxation.
How Do Mutual Funds Pay Dividends?
Yes, mutual funds also roll out dividends, if the investors have chosen to select the dividend option under the said scheme while investing in the scheme. Mutual funds can pay such dividends only from their gains. These gains are from mainly two sources:
- Sale of securities from the fund
- Current incomes, such as dividends and interest
Moreover, the Asset Management Companies (AMCs) have to store these gains in their Dividend Equalisation Reserves. It implies that if the mutual fund is not in profit, then even if a company is distributing high dividends, unitholders will not get the benefit. We suggest that investors read the scheme information document before investing.
Dividend Options
There are two options provided to the investors while selecting the mutual funds:
- Growth option
- Dividend option is now known as IDCW (Income Distribution cum Capital Withdrawal)
In the growth options, all the potential returns on the plan of the scheme are accumulated and are not distributed as disbursed when there is profit under frequencies mentioned in the dividend option. While in the dividend option, this fund is distributed among the investors as per their preference i.e. frequency. Investors can claim the distribution or re-invest in the scheme, as per their preferences.
Today this option is known by a different name – Income Distribution cum Capital Withdrawal (IDCW).
What is IDCW in Mutual Funds?
From April 2021, the name of dividend options was changed to IDCW for better awareness of mutual fund investors. The name mentioned ‘income’, which comprehensively explains that it may consist of dividends, incomes such as interest, and capital appreciation due to the sale of investment. Moreover, the term ‘capital withdrawal’ explains that it is not a separate gain over an investor’s redemption value but a part of it.
The schemes were known as Dividend Payout, Dividend Re-investment, and Dividend Transfer Plan. SEBI changed the names in the following manner:
- Payout IDCW
- Reinvestment IDCW
- Transfer IDCW
The IDCW option declares dividends as regular, daily, or weekly. Like stocks, a record date is announced, and the dividends are distributed. The NAV falls to the extent of dividend payout/declared.
There is a misconception that when a fund has a dividend option, it generates more than regular profits to distribute the dividend among the investors. However, profits don’t differ in growth and dividend options. Profits are the same for the fund, and the only distinction is by the amount paid to investors in case of a dividend option or reinvested in a scheme under the growth option.
There is also another misconception that dividend options pay an extra income, and its Net Asset Value (NAV) is high. Before the distribution of dividends, the profit earned is reflected in the total value of the fund, which thus increases its NAV. When this dividend is distributed, the NAV falls to the extent of the dividend payout.
Let us understand IDCW with an example.
Ms Abc has a corpus of ₹2 lakh in the mutual funds. She has opted for the IDCW plan. The following would be her dividend pay:
| Total amount invested | ₹2 lakh |
| Total units | 1000 |
| NAV per unit (before dividend payout) | ₹200/- |
| Dividend per unit | ₹6/- |
| Total dividend | ₹6000/- |
| Ex-dividend NAV (after) | ₹194/- |
| Total investment after dividend | ₹1.94 lakh |
(The above figures are for illustration purposes only)
As this example explains, the ₹6/- dividend is distributed from the NAV, and thus, profits do not differ for growth and IDCW options. They are either kept in the fund or distributed among the investors, depending on the option selected by the investors.
Usually, investors think that the dividend yield funds and the dividend options are the same. But they aren’t.
Dividend Yield Funds
These funds are categorised under equity mutual funds. They invest at least 65% of their funds in equity instruments, and these are the ones yielding potential dividend income.
The main focus here is to invest in the equity of companies with high dividend yields and not just high dividend rollouts. The dividend yield is calculated against the investment made. For example:
We hypothetically invest in an equity instrument at ₹120/-. It distributes 30% dividends on its face value of ₹10/- per share. So, dividend per share is ₹3/-.
The dividend yield would be 0.025 or 25% (3/120).
Taxation of Dividend yield funds is as follows:
- Short-term capital gain tax = 20%
- Long-term capital gain tax = 12.5%
Investors should consult their financial advisors before investing.
Let us understand dividend yield funds with an example.
HDFC Dividend Yield Fund-Direct-Growth
| 1 year | 3 year | Since Inception | |
| Scheme Returns (%) | 47.63 | 28.55 | 32.23 |
| Benchmark Returns (%) | 39.15 | 21.05 | 23.59 |
| Additional Benchmark Returns (%) | 27.76 | 17.86 | 19.29 |
Source: HDFC Direct Yield Fund
In equity, its top holdings have potential dividend yields. These are as follows:
| Name | % of total holding | Dividend yield |
| HDFC Bank Ltd. | 6.10 | 1.22% |
| ICICI Bank Ltd. | 4.27 | 0.83% |
| Axis Bank Ltd. | 3.56 | 0.09% |
| Larsen and Toubro Ltd. | 3.03 | 0.78% |
| Tech Mahindra Ltd. | 2.80 | 2.63% |
Source: HDFC Direct Yield Fund
Selecting a dividend yield fund doesn’t imply that the earned dividends will be straightly transferred to the investors; it ultimately depends on the investors’ choice, like every other fund. The dividend earned in these funds is distributed or reinvested as per the preference of investors regarding growth or the IDCW option mentioned in the application form.
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Difference Between Dividend Yield Funds And Dividend Options
Usually, investors think that the dividend yield funds and the dividend options are the same. However, these two are not similar, and only the dividend option for any particular fund (not necessarily dividend yield funds) generates the dividend income. Their difference can be further discussed as follows:
| Dividend yield funds | Dividend options (IDCW) |
| They are an equity mutual fund category. | These are options offered in different mutual funds. |
| They invest in high dividend-yielding stocks. | They pay a dividend from the mutual fund’s profit. It includes income from dividends or interest along with the sale of securities. |
| Example: HDFC dividend yield fundHDFC dividend yield fund direct growth, HDFC dividend yield fund direct IDCW (payout and reinvestment scheme) | Example: HDFC dividend yield fund direct IDCW (payout and reinvestment scheme) |
Taxation of Dividends By Mutual Funds
In April 2020, the dividend distribution tax was abolished, and the dividend became taxable at the receiver’s hand. In mutual funds also, the taxation of the dividend received is as follows:
- Dividends income under IDCW: As per the unitholder’s slab rate
- The tax would be deducted at source (TDS) on this income:
10% (Indian citizens) & 20% ( Non-Resident Indians)
- TDS is applicable as above if the dividends received per AMC are more than ₹5000/- for a financial year.
Conclusion
Mutual fund unitholders may receive dividends from dividend options (or IDCW). This dividend is paid by mutual funds from its dividend equalisation reserves. So, this reserve is the amalgamation of incomes like dividends, interest, and capital appreciation.
Also, the dividend yield fund and the dividend yield option (IDCW) are not identical. Dividend yield funds are invested in equity instruments with high dividend yields. The IDCW/dividend option provides frequent dividend income, but that dividend is out of investors’ appreciated capital.
Hence, investors should have a correct knowledge of how dividends are paid by mutual funds and should evaluate them before investing. Vaguely selecting the funds only for dividends may hamper the compounding effect and, eventually, the investor’s corpus.
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Frequently Asked Questions
How are dividends paid on mutual funds?
Mutual funds pay dividends as per the units. They cannot directly pay the dividends earned from companies. Funds must become profitable by selling the securities and earning incomes like dividends and interest to distribute the dividends. They create a dividend equalisation reserve, where they store the dividends earned from companies, and then the trustees decide upon its distribution.
How do I claim dividends from mutual funds?
If investors have a dividend yield fund or have opted for mutual funds with a dividend option (IDCW), one can claim his/her dividend when it is declared. Updates regarding the declaration of dividends are informed to customers on their registered email IDs. This dividend earned seeks to facilitate regular income for the investors, but it also diminishes the compounding effect as it is a part of the mutual fund.
Do mutual funds go down when dividends are paid?
When dividends are distributed among the investors on the record dates, NAVs increase, and as soon as the dividend is distributed, it falls to the extent of NAV payout. The reason for this is that the dividend is paid out of appreciated capital (NAV per unit). Let us simplify with this example:
- Mr. K has a corpus of ₹12000/- in the mutual fund. He has 30 units of NAV ₹400/- before the dividend is distributed. Now, the dividend is announced as 5/- per unit.
- So, Mr. K’s dividend would be ₹150/- (30*5). However, this dividend would be paid out of the NAV. So, it would be ₹395/- (400-5), post dividends are distributed.
- So earning a dividend of ₹150/- would also decrease his total investment to ₹11,850/- (395*30).
What are the disadvantages of dividend options under mutual funds?
Dividend yield funds are invested mainly in companies with high dividend yields. However, they have some disadvantages, such as:
- It diminishes the compounding effect and thus decreases the growth.
- The dividend is paid only if the fund is profitable overall with all incomes and security sales. So, it depends on the fund whether the investor will get a dividend or not.
- Since April 2020, the abolition of the dividend distribution tax (DDT) has led to tax liability shifting to investors. So, earning a dividend is taxable.
Is mutual fund dividend tax-free?
The mutual fund dividend is not tax-free. It charges tax as per the investor’s total taxable income slab rate. Moreover, 10% (Non-NRIs) and 20% (NRIs) TDS are also charged while paying the dividends. This taxability for investors started after the abolition of DDT in March 2020.