How to make more money? Here is an option better than fixed deposits or even MIPs

To generate a regular income, the most popular options are fixed deposits (FD) or dividend plans of mutual funds. Fixed deposit’s 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 an even better way to go about this with a systematic withdrawal plan or SWP?

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

Capital and returns

SWPs for income generation is usually recommended from debt-oriented funds given their stability and lower risk compared to equity funds. So consider Rs 5 lakh is invested in an ultra short-term fund and a long-term debt fund. We also threw in a 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.

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 the highest tax slab, 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 main component is taxed as opposed to the entire dividend amount being taxed under the dividend option. Hence, even for less than three year periods, the tax is lower in systematic withdrawal than in dividends.

When the withdrawal extends for more than three 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 MFs are not a certainty. Even if you have chosen monthly dividend option for a particular fund, the fund is not mandated to pay out a 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 number of dividends keep varying. Funds can pay a dividend only out of the surplus or actual profits they make. Since these are not steady, the dividend amount will fluctuate over time.

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 depend on the amount of corpus and the tenure in consideration.

Setting up an 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.

By, Ashwini Arulrajhan
(The writer is research analyst - Mutual Fund Research, FundsIndia.com)
Source: DNA Money