An SIP is systematic investing, but want if you want to withdraw systematically? Is that possible? That is where systematic withdrawal plans (SWP) comes in handy. One can argue that if you want regular income, you can as well opt for a dividend plan as compared to a systematic withdrawal plan. In fact, there are two ways to structure a payout. Firstly, you can opt for a dividend plan that pays out regular dividend on the fund corpus. Remember, dividends can be paid by mutual funds only on returns earned and not out of principal. The fund may have earned this return as dividends, interest or capital gains. That means; dividends are never assured; not even in debt funds. The second option is to structure a SWP to withdraw a fixed sum each month. This withdrawal will have a principal component and a capital gains component. What then is the big advantage of a SWP?
5 reasons why SWPs score over dividend plans
Systematic withdrawal plans give you a predictable and tax efficient method of planning your flows. Here are the advantages that SWP proffers over the dividend plan.
Remember, dividends can only be paid out of actual returns generated by the fund. You cannot pay dividends out of capital. That means if you are looking at assured dividends, then technically it is not possible. There is an uncertainty element to it. On the other hand, SWPs are withdrawal of principal plus returns. Hence you can predict your flows better. On some months you may withdraw more of principal and in some months you may withdraw less of principal. That is because your withdrawal has a principal and a return component to it.
It is possible to plan your outflows better with a SWP. For example, if your monthly cost of running your household is Rs.1 lakh, then you can structure the SWP in such a way that it pays you Rs.1 lakh on a fixed basis. Whether it pays out of principal or returns is immaterial as what matters is that you are assured of the cash flow.
SWP fit better with your long term financial plan. Your long term financial plan is all about predictability. There is no predictability about dividends but there is a lot more predictability about SWP payouts.
There is a pragmatic argument in favour of SWPs. Once you have discharged all your responsibilities, there is no compulsion on you to leave any corpus. So you can play your corpus in such a way that you draw down the corpus completely over 20-25 years. That gives you higher flows and greater flexibility.
Finally, the preference for SWP is all about tax efficiency. Dividends on debt funds are not taxed in the hands of the investor but they do entail 29.12% dividend distribution tax (DDT). So your retention is only 70.88% of the dividend paid out. To that extent the impact is almost as bad as interest on FDs, which are also taxed at your peak rate. When you structure a SWP, you only pay tax on the capital gains portion not on the principal component portion. That is why SWP works out more economical. Let us see in detail how the SWP scores over a dividend plan.
How an SWP scores over a dividend plan?
Assume that Sheila has a corpus of Rs.2 crore when she retires at the age of 60. She decides to invest the entire Rs.2 crore in a liquid fund. Since the liquid fund is likely to yield 5%, she will get an annual flow of Rs.10 lakhs per year as dividend or Rs.83,333 per month. That is lower than the income of Rs.1 lakh that Sheila is looking at. That is just one side of the problem. When the fund pays out Rs.83,333 per month as dividend, it deducts 29.12% as Dividend Distribution Tax (DDT). Effectively, Sheila gets on Rs.59.066 on hand. That is substantially lower than her target monthly flow of Rs. 1 lakh per month. That is where SWP comes in handy.
YearCorpus in liquid FundAnnual Interest
income 5%Annual Withdrawal
via SWPClosing BalanceYear 1200,00,00010,00,00016,05,000193,95,000Year 2193,95,0009,69,75016,05,000187,59,750Year 3187,59,7509,37,98816,05,000180,92,738Year 4180,92,7389,04,63716,05,000173,92,374Year 5173,92,3748,69,61916,05,000166,56,993Year 6166,56,9938,32,85016,05,000158,84,843Year 7158,84,8437,94,24216,05,000150,74,085Year 8150,74,0857,53,70416,05,000142,22,789Year 9142,22,7897,11,13916,05,000133,28,929Year 10133,28,9296,66,44616,05,000123,90,375Year 11123,90,3756,19,51916,05,000114,04,894Year 12114,04,8945,70,24516,05,000103,70,138Year 13103,70,1385,18,50716,05,00092,83,645Year 1492,83,6454,64,18216,05,00081,42,828Year 1581,42,8284,07,14116,05,00069,44,969Year 1669,44,9693,47,24816,05,00056,87,217Year 1756,87,2172,84,36116,05,00043,66,578Year 1843,66,5782,18,32916,05,00029,79,907Year 1929,79,9071,48,99516,05,00015,23,903Year 2015,23,90376,19516,05,000-4,902
When the same corpus is structured as a SWP with 5% returns, Sheila is able to withdraw Rs.16.05 lakhs per year or Rs.1,33,750 per month. That is a lot more comfortable for Sheila to cover her expenses. The tax will be only charged on the capital gains portion and hence will be much lower after 3 years are completed. After spending her monthly Rs. 1 lakh, she will still be left with a neat surplus which she can invest. This corpus will last her ill the age of 80. SWP surely makes a lot of sense in the case of Sheila.