You’ve probably heard of Systematic Investment Plans (SIPs). But the SIP’s sibling — the SWP — is an equally useful tool.
A Systematic Withdrawal Plan, or SWP, is a method by which you can withdraw money that is already invested in a mutual fund through equal instalments spread out over time. When you set up an SWP, the fund house automatically redeems some of your accumulated units each month in such a way that you receive the same payout every month.
To illustrate, let’s assume you have 1,000 units in a debt fund today with an NAV of ₹500 per unit and set up a monthly SWP of ₹10,000. If the fund’s NAV rises to ₹505 per unit in the first month, the fund house will redeem 19.8 units (₹10,000/505) to pay your installment. In the second month, if the NAV dips to ₹495, it will redeem 20.2 units to pay your installment of ₹10,000.
Thus, NAV fluctuations will effectively decide how many accumulated units will be redeemed, to sustain your monthly payout.
SWPs in equity funds
SIPs help you spread out your investments in an equity fund over an extended period, so that your returns are not too badly affected by a poorly timed entry (say, at a market peak). SWPs do exactly the same thing for your exits.
They phase out your withdrawals over many months, so that your returns are not unduly impacted by bad timing. The longer your investment horizon and the higher the corpus you’ve built, the more important it is to use an SWP to exit from an equity fund. For critical life goals such as retirement, it would be ideal to start SWPs 2-3 years ahead of the goal, so that your hard-earned corpus isn’t held to ransom by sudden market declines.
SWPs in debt funds
Debt fund returns, just like equity fund returns, may fluctuate from month to month based on bond price moves. With a debt fund SWP, you can secure a predictable monthly cash flow by redeeming outstanding units. The SWP route is, in fact, being increasingly preferred over the dividend route for receiving regular ‘income’ from debt funds owing to its tax-efficiency.
Thanks to tweaks in tax laws over the years, debt funds are today required to deduct a Dividend Distribution Tax (DDT) of 29.12% (basic tax plus surcharge and cess) before distributing any part of their returns as dividends to their investors. This large tax cut at source takes a big bite out of your returns.
This has pushed many retirees and regular income-seeking investors to switch from dividend to growth plans of debt funds using SWPs.
In contrast, returns you earn when you redeem units by way of SWPs from debt funds are taxed as capital gains. When your holding period on a debt fund is less than 36 months, the return component on the SWP is taxed at your income tax slab rate. For holding periods of over 36 months, it is taxed at a flat 20% with indexation benefits.
Your tax incidence in either case is quite low compared to other fixed income options such as bank deposits. This is because while your entire income from a bank deposit is treated as a return on your capital and taxed at your slab rate, your cash flow from a SWP consists of both a capital component (because you’re redeeming units) and a return component. Only the latter part attracts capital gains tax.
Given debt funds accrue returns gradually, in the initial two years of using a SWP, your return component will be far lower than the capital component you’re withdrawing, leading to a low tax incidence.
Once a three-year period is complete, inflation indexation on your costs come to your rescue. Long-term capital gains tax is levied only on the returns you make over and above the inflation rate.
The caveats
While SWPs may seem tempting to earn a regular cash flow from your fund without shelling out high dividend tax, there are a couple of caveats you need to keep in mind.
One, though SWPs may give you income-like cash flows from an equity or debt mutual fund, you mustn’t lose sight of the fact that you are withdrawing from your capital as well as accumulated returns when you use a SWP.
If you have SWPs running on your equity fund when the stock market is tumbling, you would be selling units at low stock prices, losing out on the opportunity to participate in the rebound to the extent of the redeemed units.
This makes it risky to use SWPs to seek a regular ‘income’ from funds with volatile returns such as equity or equity-oriented funds. In equity funds, SWPs are best used to redeem your final corpus.
Two, given debt fund returns are also market-linked, the risk of withdrawing from your capital exists in debt fund SWPs too. To ensure that you’re not drawing down your capital in your search for regular cash flows from debt funds, you need to estimate their likely annual returns and make sure that your withdrawal rate via SWP is below the likely return for the year.
Tracking the returns on the funds on which you have SWPs set up is imperative to ensure that there are no disappointments.
