Prateek Sinha got Rs 25 lakh as provident fund dues on retirement. He wants to invest Rs 10 lakh in a scheme that gives him regular income. His financial adviser has suggested two options - a bank monthly income scheme (MIS) and a mutual fund monthly income plan (MIP). Both offer regular income.
However, Sinha prefers a bank MIS over a mutual fund MIP. The reason: Bank MIS offers guaranteed income.
A bank MIS is like a bank fixed deposit where interest earned is paid at regular intervals. The interest rates are the same as the prevalent fixed deposit rates. An MIP is a debt mutual fund scheme which invests a small part of the funds (15-25 per cent) in equities. It offers regular income in the form of periodic (monthly, quarterly, half-yearly) dividend payouts.
Due to the presence of equity, MIP returns can be volatile. At times, the scheme may suffer losses, making dividend payouts irregular - both in quantum and frequency. The scheme may, at times, not pay any dividend at all. In spite of this, MIPs of mutual funds can offer higher returns after adjusting for tax and hence can be a better option.
Investors wary of fluctuating income from MIPs' dividend option can opt for a systematic withdrawal plan, or SWP, which allows regular redemption of a pre-determined amount. An SWP under an MIP can work as a regular source of income for investors, just like in a bank MIS.
In a mutual fund scheme, dividend is paid at the discretion of the mutual fund house. The payouts depend on the availability of surplus cash.
Even under MIPs which promise regular dividend, it is not mandatory for mutual funds to pay at stated intervals. Since MIPs invest 15-25 per cent funds in equity, many fund houses fail to pay when stock markets are falling.
Opting for a systematic withdrawal plan (SWP) reduces the risk of irregular cash flow. Even when the scheme is making losses, it will pay the amount opted for by the investor by digging into the principal, if needed.
- Quantum, frequency of payout decided by fund houses
- Payouts made only from the capital appreciation portion
- Principal remains untouched as dividends are paid from capital appreciation portion
- A 12.5 per cent dividend distribution tax is deducted from the payouts
- Investors decide both quantum and frequency of payouts
- Payouts can be made from capital appreciation and principal
- Principal amount may erode if capital appreciation is less than each payout instalment
- Investors are liable to pay capital gains tax - short/long-term
In contrast to this, under the dividend option of MIP, the investor's principal remains untouched. Only the capital appreciation portion is distributed.
"SWP is useful when the investor wants a fixed amount at regular intervals. In the dividend option, the quantum and frequency of payouts are not fixed," says Ganti Murthy, head, fixed income, Peerless Mutual Fund.
SWP works better when a person invests a large sum. "In a small investment, if the return generated is less than the regular payouts, it will fast erode capital," Murthy says.
To understand this, let us consider a situation where a person invests Rs 1 lakh and opts for withdrawal of Rs 1,000 every month. If the MIP generates a 10 per cent annual return, or 0.83 per cent per month, Rs 830 out of Rs 1,000 will be paid from the scheme's profits and the balance, that is, Rs 170, from the capital.TAX GAIN
Since equity investment in MIPs is less than 65 per cent of the portfolio, they are considered as debt funds and taxed accordingly.
The dividend paid by debt funds is not taxed in the hand of investors, but a dividend distribution tax (DDT) has to be paid by the mutual fund company.
A DDT of 12.5 per cent (excluding education cess and surcharge) is deducted from the dividend paid by debt funds other than liquid and money market funds. Therefore, all dividends under MIPs are paid after DDT deduction.
Long-term capital gains (redemption after a year) from debt funds are taxed at 10 per cent without indexation and 20 per cent with indexation. Indexation is adjusting the purchase price with inflation. It reduces real capital gains and, hence, the tax liability. Short-term capital gains are taxed at the normal income tax rate.
In SWP, the investor has to pay short- and long-term capital gains tax. The short-term capital gains tax can be avoided if the investor goes for systematic withdrawal after one year of investing.
Renu Pothen, research head, Fundsupermart.com, an online mutual fund distributor, says if the SWP starts after one year, the tax liability is relatively lower than that under the dividend route.