Why SWPs are great for regular income – Part I

When you are in your salaried years, your salary will more than take care of your regular income. But there comes a time when you start depending on your investments for such needs, whether on retirement or due to any other reason.  

To generate a regular income, the most popular options are fixed deposits or dividend plans of mutual funds. FDs’ safety of principal and assured cash flows makes it an attractive option. But when it comes to some extra income, dividend plans from debt funds and MIPs get attention. What if we tell you there’s a even better way to go about this with a systematic withdrawal plan or SWP?

In a two-part series, we discuss how you can make use of SWPs to generate optimal returns without compromising on stable cash flows. This week, we’ll show how SWPs stack up against the dividend option. In the next part, we’ll compare FD and SWP.

SWP is an option where you periodically (usually each month) redeem a specific amount from your mutual fund investment. You can decide the amount and change it anytime you wish to. It’s the inverse of an SIP, where you invest each month.  But proposing SWP as the better alternative to dividend plans usually meets some opposition, encapsulated below. 

By using an illustration, we are going to debunk some of the myths for you.

Capital and returns

SWPs for income generation are usually recommended from debt-oriented funds given their stability and lower risk compared to equity funds. So consider Rs.5,00,000 in invested in an ultra short-term fund and a long-term debt fund. We also threw in an MIP, given that several investors are attracted by their dividend options. We compared monthly dividend plan and monthly SWP in growth plan, assuming you invested in February 2013. The table below shows what returns you would have made in these two options had you invested 5 years ago in Feb 2013. The average monthly withdrawal is a close approximation to the average dividends paid out during the period.

• *Dividend distribution tax is reduced from your NAV, i.e., you are indirectly paying the tax. DDT rates considered are the applicable period’s prevailing rate, since DDT rates have changed over the years.
• Tax on SWP is considered at 30.9%.

For the same investment amount, the returns made from these two options are significantly different. Growth plans were able to generate almost two percentage points more even while providing regular income in the form of withdrawals.

The misconception about capital erosion by using SWP also becomes clear from the illustration. Even  with withdrawals starting from the very next month following the investment, a growth plan was able to deliver better returns in the end. As long as the returns made by the fund are more than your withdrawal rate, your capital would still be earning returns for you and remain intact. That means if you have a realistic withdrawal expectation based on the fund’s return, you will not be reducing your capital.

Taxation

In an SWP, each withdrawal is a redemption and will incur capital gains tax, long term or short term depending on the period. Short term capital gains tax is taxed at income tax slab while long term capital gains tax is taxed at 20% with cost indexation.

Dividends aren’t tax-free, either. Dividends have taxes deducted by the AMC and what you get is the dividend net of Dividend Distribution Tax (DDT). The current DDT rate for debt fund dividends is  25%; from this fiscal onwards, dividends on equity funds, including balanced funds, will have a DDT of 10%. Including surcharge of 12% and cess of 4%, the rates stand at 29.12% for debt funds and 11.65% for equity funds.

Therefore, dividends are not tax-efficient, especially when it comes to debt funds. Withdrawing from the growth option and paying a capital gains tax involves lower tax outgo.Even in highest tax slab of 30% (as assumed in the example), the tax outgo is much lower for SWP.

Why is there such a large difference between the tax you pay on SWP and compared with what you pay on dividends? It is so for the following reasons:

• One, in the systematic withdrawal plan, every time you redeem, only a part of the redemption is your gain. And only the gain component is taxed as opposed to the entire dividend amount being taxed under the dividend option. Hence, even for less than 3 year periods, the tax is lower in systematic withdrawal than in dividends.
• When the withdrawal extends for more than 3 years, you gain long-term capital gain indexation benefit and this makes you more tax efficient than the earlier years!

Regularity of income

Dividends in mutual funds are not a certainty. Even if you have chosen monthly dividend option for a particular fund, the fund is not mandated to pay out dividend every month. That’s a decision made every time by the fund manager. You may go by a fund’s a healthy track record of dividend payments, but that doesn’t assure you future dividend consistency.

More importantly, the amount of dividends keep varying. Funds can pay dividend only out of the surplus or actual profits they make. Since these are not steady, the dividend amount will fluctuate over time.

The graph below shows dividends paid out by ICICI Prudential MIP 25 fund from Feb 2013 to Feb 2018. The maximum dividend paid out during this period is Rs.6255 in Oct 2013 and minimum being Rs.939 in Jan 2014. And there was no dividend at all for the month of Aug 2017. When you are dependent on dividends, uncertainty in dividends paid out becomes a problem. By using an SWP, your cash flows would be regular.

Setting up SWPs

SWPs can be set up in a combination of debt funds, usually liquid, ultra-short term debt, and longer term debt funds (including MIPs). The mix and match between fund types depends on the amount of corpus and the tenure in consideration.

Setting up a SWP is a simple process and a one-time exercise. All you need to do is fix the date on which you want to redeem from your fund, the frequency (monthly/quarterly/etc), and the amount.  

SWPs thus let you decide the frequency with which you want periodic income, what time of the period (beginning/end of a month) you would like to receive it,etc. This puts you in better control of your finances unlike in a dividend plan where the quantum and frequency of dividends is uncertain.