Systematic Withdrawal Plan - A Plausible Option for Regular Cash Inflows
Systematic Withdrawal Plan has an edge over dividend option…
Mutual Funds often pay dividend out of realized gains/ profit to investors under dividend option on different frequency such as monthly / quarterly / yearly etc. Investors looking for intermittent cash flow generally prefer such option. However, in view of changed tax laws regime in respect of dividend distribution tax and capital gains last year, dividend option has lost its sheen and Systematic Withdrawal Option (SWP) has emerged out as a preferred option. Investor can instead choose SWP where the possibility of compounding effect is higher than that of dividend option.
Dividend has a cost attached to it …
Dividends do make a lot of emotional sense but less of economic sense. Till March 2018, it did not matter as there was no cost attached to it. However, investors should realize that since 1st April 2018 onwards there is cost attached to such dividend which comes in the form dividend distribution tax @ 11.648% (equity funds). In simple words if a fund has to pay a net dividend of Rs. 10/- in an equity fund, the fund has to have a surplus of Rs. 11.3200 after factoring 11.648% (10% DDT + 12 % surcharge + 4% Health & education cess) as tax .The Investors should note that this is an extra charge which needs to be factored in for arriving the net pay-out. The impact of this can be severe when the underlying fund has moments of underperformance due to adverse market conditions.
Systematic withdrawal Plans (SWPs) - A more plausible option…
Investor can aim for a cash inflow which is fixed and steady for considerable time period in a better & tax efficient way. (Subject to availability of sufficient balance in the folio account)
The answer lies in opting SWPs which facilitates a regular and predictable cash inflows. This also defends from paying unwarranted statutory charges (DDT) related to dividend pay-out. Investors can give a simple mandate of structuring SWP by opting frequency, tenure and amount of withdrawal in a tax efficient manner. Investors may plan their expense management (pre & post retirement needs) and other requirement such as child’s school fees, monthly house rent etc. with the help of an SWP.
Couple of thoughts on the merit of SWP over dividend option,
- Steady cash inflows: - SWP facilitates a predetermined pay-out on a monthly / quarterly basis as opted by the investor. (Subject to availability of sufficient balance in the folio account) However, under the dividend option this pay-out frequency is not a certainty and is at discretion of the fund house. If there is no distributable surplus or little surplus, funds may skip paying dividend or reduce the quantum of dividend which can leave investor short for his needs. In short, regularity of cash inflows is what SWP ensures and investors can be in better control of their finances.
- Tax advantage:- This aspect has more relevance as discussed below, particularly in the wake of change in tax laws since 1st April 2018,
- Dividend Distribution Tax - This aspect has already been discussed under the heading “Dividend has a cost attached to it”. The DDT in respect of Debt and liquid funds was already applicable @ 29.12%.
- Capital Gains Tax: The receipt of money through SWP takes place after redemption of units and hence there will be an incidence of capital gains tax. The long term capital gains tax (above 1 year) on equity fund is @10% and for debt (above 3 years) @20% with indexation benefits. SWP can boost the post-tax-returns of an investor irrespective of the timing of SWP instalments. SWP is tax efficient on account of the following,
- Upto ₹1 lakh of LTCG is tax exempt for the investor. Moreover, even if the capital gains is more than one lakh, incidence of capital gain will be in respect of capital gains above one lakh, thereby reducing the overall tax liability.
- Under SWP the amount of withdrawals can be split as principal and capital gains, if any short capital gain or long term capital gain is due only on the capital gains and not on the principal amount the tax incidence will apply . Hence, tax as a percentage of the amount withdrawn is much lower than the capital gains tax rate. Especially, when capital gains are minimal or not there, during times when the markets hit a bearish phase, there may be no incidence of capital gains tax but under the dividend option taxation is agnostic to gain and loss and any outflow of dividend will be at a flat rate of 10% plus surcharge & cess, even if the underlying fund has not provided any gains.
SWP Inculcates discipline and circumvent from timing the markets: - Just as discipline is important while investing it is equally important that we remain disciplined at the time of withdrawal as well. SWPs force one to be committed to redeem across various cycles of the market- be it bearish or bullish and helps one to moderate the market extremes.
The success of SWP is dependent on our approach and its application in alignment with our investment objective. Investors while opting for SWPs can put a realistic amount of withdrawal and that amount should not be higher than the return generated by fund. If we put an un-realistic amount, chances are that we may run the risk of eating away the principal and leaving a smaller base to get the benefit of compounding. The other point which could work to the advantage is that we allow some time for investment to grow before we start withdrawing.
The above note is prepared by Product Team - Hybrid and released in Feb 2019.
Investors may consult his advisor / tax consultant to take an independent view. The tax guidelines / rates mentioned are applicable as on date. Mutual Fund investments are subject to market risks, read all scheme related document carefully.