The recent introduction of a 10% tax (DDT is equal to Dividend Distribution Tax) on income distributed by equity funds has made investors who are used to earning tax-free dividend, a little uncomfortable. The dividend distribution tax (DDT) has affected those who have opted for the regular dividend option in equity funds.
While dividend from some equity mutual fund schemes continue to pay attractive after-tax dividend yields, the investor should realize that treating equity on par with a fixed income product can turn out to be a very risky proposition. Since the DDT has reignited this conversation, let us look at another option that could be prove to be a good blend of returns, regular income and tax-efficiency. A systematic withdrawal plan (SWP) can be that alternative.
Both growth and dividend options of equity schemes benefited from zero taxation earlier if held for more than 12 months. The recent DDT now makes the growth option preferable as investors can continue to claim exemption on capital gains up to Rs 1 lakh from all sources. Under the dividend option, any dividend paid by the scheme will attract 10% tax, irrespective of the amount.
The dividend will be deducted by the mutual funds itself and not taxed in the hands of the investor. Systematic Withdrawal Plan (SWP) allows one to set up regular and automatic withdrawals from mutual funds (MFs). Think of it as an opposite of a Systematic investment plan (SIP). Like SIP, SWP too can be a great tool. This can be used by investors to manage a part of their post retirement withdrawals from the corpus. Thus one can leverage SWP as a tool to manage investments, save on taxes, avoid exit loads and save efforts. All the more, it supports the strategic efforts to achieve one's goals.
When SWP is set up, the AMC simply liquidates pre-decided number of units or a fixed amount and transfers the proceeds to investor's bank account on a specified day at regular pre-decided intervals.
One of the biggest challenges for investors requiring regular income is to beat inflation and be tax-efficient. As a result, investors get defensive and prefer safer investments. Due to this, the investor loses out on the opportunity to earn. In such a case, an investor can opt for investing part of his corpus into a debt plan for the first five years of retirement and simultaneously invest in equity mutual funds. This arrangement gives time for the equity investment to grow. From the 6th year onwards, the investor can then start withdrawing from the accumulated corpus in the equity mutual funds. In the long run, equities have proven to beat inflation and since LTCG is taxed at a concessional 10%, this option would be tax efficient as well.
When one has invested in an ELSS fund through SIP and needs to liquidate at one go, it becomes inconvenient since every installment invested has a three years lock-in. Using SWP in such cases will ensure that this process is smoothened out and hassle-free.
SWP facilitates lot of convenience. Multiple transactions over a period can be setup through a single SWP. This saves transaction costs and monitoring. More importantly, it helps one to achieve strategic objectives since the amount of withdrawal per month is under the investor's control. So he/she can decide the monthly withdrawal necessary according to his/her requirements and set it up accordingly.
If a person, in 30% tax slab, has invested his money in debt mutual funds, SWP can boost the post tax-returns. Considering the investment is in growth option of a debt fund, after three years, the investor can start withdrawing money. Such withdrawals will be treated as long term capital gain and will be taxed at 20% rate of tax post indexation.
If the investor opts for a dividend option, all dividends will attract tax at the rate of approximately 29.12%. By opting for SWP in growth option not only does the investor get to reduce the tax liability, but also can fix the amount of money he needs per month. As dividends are not guaranteed, there is always an element of uncertainty on the quantum of money he receives per month under dividend plan.
For equity mutual funds, SWP is more tax efficient as Rs 1 lakh of LTCG is tax exempt, while dividends are taxed at a flat rate of 10%. Also, an investor of small sum, may be able to avoid tax on his gains, if the LTCG accrued on the amount withdrawn during the full year under the SWP remains below the Rs 1 lakh threshold. The only catch is that in equity funds, the investor should start withdrawing only after 1 year to avail the concessional LTCG taxation. For debt funds, the investor has to wait for 3 years.
Assuming an equity investment earns 12.5% p.a., the investor can withdraw Rs 9 lakh tax-free during the year (Rs 1 lakh capital gain and Rs 8 lakh principal required to earn that gain @ 12.5%). There is no tax on capital withdrawal and LTCG up to Rs 1 lakh is exempt. On the other hand, if the investor intends to earn the same Rs 9 lakh from dividend option, he/she will incur a tax of Rs 104,832 (11.648% DDT on Rs 9 lakh) in the same year and the net take home will be lower.
This calculation will work similarly for debt funds where the DDT comes to 29.12% and the tax on LTCG is 20% after indexation. An SWP options scores over a regular dividend paying scheme in terms of taxation, investor's control over the payout and its frequency and risk management according to the investor's risk appetite.
That is not to say investors should discontinue their dividend plans. SWP option should be used along with dividend plans for better risk management and adequate regular inflows. Investors who have previously been too risk-conscious can use this alternative to boost their accumulated wealth.
Deepak Jasani is head, retail research at HDFC Securities