Retired people or people having no regular sources of earnings with an investable lump sum amount can earn regular income in different ways. In India most popular instruments that can generate a regular income or can help someone withdraw money at regular intervals are:
# Post Office MIS (Monthly Income Scheme)
# Fixed Deposit
# Senior citizen saving scheme
# Monthly Income Plan of mutual funds (MIP)
# SWP from mutual funds (Systematic Withdrawal plan)
# Dividend from Mutual funds
# Dividend from Equity
# Annuity from Insurance companies
# Rent from Real Estate
# Long term Government Bond
People who mainly depend on fixed deposits or post office monthly income schemes for regular income often don’t realize that their money is losing value due to inflation. Their deposits continue to give out a fixed amount although their monthly requirement gradually goes up due to inflation. However, in the last three years monthly incomes have come down as much by 25 per cent as the interest rates have come down from 8.5 % to 6.5%. Those in the highest tax bracket feel the pinch the most as post-tax returns from deposits have come down to nearly 5 per cent. Keeping all this in mind, some of the alternatives that can be considered are monthly income plans (MIPs) and systematic withdrawal plan (SWP) in a debt mutual fund.
Monthly Income Plans (MIPs)
The Monthly Income Plan option for a regular income involves investing in Debt Mutual Funds with a monthly divided option. Most of these funds are conservative in their investment approach and allocate only 10-20% of their corpus into equities and the rest 80-90% in safer bonds and other debt instruments. The returns are not spectacular as compared to equity funds because of lower risk, but are enough to beat inflation. The attractiveness of MIPs is the relative safety they offer as these funds give investors good returns if stock markets do well, but they also protect the downside because of the limited exposure to equities.
From the taxation point also, MIPs are better than fixed deposits as the interest from fixed deposits is fully taxable. The post-tax returns from a fixed deposit that offers 8% are actually 5.6% for a person in the 30% tax bracket and this income is taxed every year even though he may get it only after the deposit matures. Also, if it exceeds a certain limit, it attracts TDS. So, there is no escape. On the other hand, gains from MIP funds are taxed only when the investor redeems the investment. Even then, only the gains are taxed and that too at a lower rate.
Investors should, however, be aware that though these plans are called “monthly income plans”, there is no assurance of monthly income. In fact, the dividend option of these funds is a very tax inefficient way to get a monthly income. Though the dividend received is tax-free, it comes to you after a heavy 28.84 per cent (25 per cent tax + 12 per cent surcharge + 3 per cent cess) dividend distribution tax on debt fund and 10% on equity funds. It is better to go for the growth option of the MIP fund and redeem units as and when you need the money. You can also start a systematic withdrawal plan (SWP) under which a fixed sum is redeemed every month and put into your bank account.
MIPs can be good source schemes for systematic transfer plans (STP) into equity funds. In an STP, a fixed sum flows out of the scheme to another scheme (usually an equity fund) on a predetermined day of the month or quarter.
Be wary of the charges though. MIPs have high charges (some charge up to 2.5%), which can be a drag on the overall returns.
Systematic Withdrawal Plan (SWP)
Another better alternative to bank FDs is a systematic withdrawal plan (SWP) in a debt mutual fund. If you have invested in equity or debt mutual funds you can generate regular monthly income from mutual funds by selecting SWP (systematic withdrawal plan). SWP is a good option for those looking for income at fixed intervals, as SWP is a facility which allows investors to withdraw a specific amount of money from a mutual fund at regular intervals.
Most commonly, two options are available for SWP’s. In the first option, a fixed amount is withdrawn at a fixed intervals that could be monthly, quarterly, yearly etc. and in the second option, the appreciated amount is withdrawn on a fixed interval.
SWP in a debt mutual fund is tax effective than a bank fixed deposit. Although the dividend received in the hands of the investor is tax free, all non-equity investments attract DDT of 28.84%. The DDT is paid by the AMCs but eventually the investor has to pay. In a SWP, each withdrawal within 3 years from the date of purchase will be treated as a short-term capital gain. The gains will be added to the investor’s income and taxed accordingly. Withdrawal beyond 3 years from the date of purchase will attract long-term capital gains tax of 20%. But since the investor will enjoy indexation benefits, it is likely that investor is going to pay a lower amount in tax based on the indexed cost.
Which option is better for you and why?
Monthly cash flow requirements and tax efficiency are two most important factors that determine whether you should opt for dividend or the SWP option or MIP option. To summarize, for fixed monthly income, MIP and SWPs are two options. Under both these options investments are made in debt mutual funds. In the Monthly Income Plan the monthly income, however, is inconsistent as it depends on market conditions. Also in comparison to SWP’s, MIP’s are less tax efficient. Therefore, if one opts for a regular income investment plan, a systematic withdrawal plan is a superior alternative.
(By Rahul Agarwal, Director, Wealth Discovery/EZ Wealth)