How does a systematic withdrawal plan help an investor?

How does a systematic withdrawal plan help an investor?

Prashanth Amin of Kolkata wants to know how the systematic withdrawal plans offered by mutual funds work and the tax implications of investing in one.

Most mutual fund investors know how systematic investment plans (SIPs) help tide over market volatility by averaging out costs during good and bad times. It’s not only a hedge against ups and downs, but also a convenient mode of investment because you don’t have to write out a cheque, fill up a slip and submit it to the mutual fund every month.

SWPs incur lower tax in debt funds
 Equity-Oriented FundsDebt-Oriented Funds
DividendsNo tax12.5-25% dividend distribution tax
SWP (within one year)15% shortterm capital gains taxIncome added to investor’s income for the year
SWP (after one year)No tax10% flat or 20% after indexation
There is also a 3% education cess on the payable tax

Systematic withdrawal plans (SWPs) are, in a way, the reverse of SIPs. In an SWP, instead of putting money in the fund, the investor redeems a fixed amount from his investment on a predetermined date every month. SWPs are especially useful for retirees who are looking for a fixed stream of income.

SWPs score over dividends in case of debt mutual funds because they incur a lower tax. Technically, an investor does not have to pay tax on the dividend received from any mutual fund. But the mutual fund has to pay a dividend distribution tax (DDT) on the dividend paid for debt-based funds. This burden is passed on to the investors by compulsorily deducting the amount from the fund’s NAV. Hence, the so-called “taxfree” dividend the investors receive from any debt-oriented fund comes to them after a deduction of DDT.

The DDT rate ranges from 12.5% in case of balanced and debt funds to 25% in case of liquid or money market funds. Only equity mutual funds, which invest at least 65% of their corpus in stocks, are exempt from DDT (see Taxation Terms).

The only way to avoid DDT in a debt fund is to go for a cumulative option and start an SWP of the amount that is needed by the investor every month. A major benefit of SWPs is the tax rate, which is lower than the DDT. The profit from the sale of units being redeemed at every withdrawal is taxable. In the first year of investment, the profits are included in the investor’s income for the year and taxed at normal rates. But after a year, the profit is treated as long-term capital gain and taxed at a flat rate of 10% or at 20% after indexation benefit. So the SWP is a better deal than the dividend option.

SWPs also help an investor customise the cash flow to suit his needs. This is especially useful if the investor does not have any other source of income. Imagine a situation where a pensioner needs Rs 10,000 a month for his expenses but the dividend from his mutual fund investment is only Rs 7,000 a month. This too is not assured. He would be better off with an SWP of Rs 10,000, wherein the SWP would deplete the corpus by around Rs 3,000 every month.

Some mutual funds charge an exit load if the investment is redeemed before 6-12 months. Make sure you take an SWP that does not attract an exit load, and if it does, start the SWP after the stipulated period.

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