Systematic withdrawal plan after three years in debt schemes, offers the best of both worlds – monthly liquidity and tax efficiency. In equity schemes, an investor could opt for dividend payout
By: Deepak Jasani
The question WHETHER to choose dividend option or systematic withdrawal plan (SWP) arises when an investor needs regular income in order to meet recurring expenses and maintain a certain standard of living.
Dividend payout option
Under this option, dividends are issued to unit holders, generally on a regular basis. This means that a part of the gains realised by the scheme is paid out to investors. The net asset value (NAV) of the scheme falls to the extent of the payout. Unrealised profits from the instruments held cannot be used to pay dividends. Dividends received from all mutual funds are tax-free in the hands of the investors. However, in the case of debt funds, the fund house pays a dividend distribution tax (DDT) of 28.84%, which includes surcharge and cess (which hurts investors in 10% and 20% tax bracket). In an equity mutual fund, there is no dividend distribution tax.
Dividend vs growth
In the growth option of a scheme you get units at the time of investment and the number of units remains the same until the end. The NAV changes according to the performance of the fund. Investors with growth option earn returns when they sell their units at a higher NAV at a later date.
In the dividend option, the mutual fund will pay you from the profits booked by the scheme at periodic intervals. However, the dividend is not an additional benefit. It should be seen as a periodic profit booking and not as an additional gain. For e.g., if a fund has NAV of Rs 50 and declares `2 dividend, the fund NAV will reduce by the same and become Rs 48.
In growth option, the investment has the power of compounding. The profits booked get added to the NAV and keep compounding over time. In order to create wealth over a long period of time, an investor (who is not in need of regular inflows) should go for a growth option. This is on the assumption that the scheme keeps earning a return that is higher than what the investor would have earned if he had received dividend and deployed it.
Systematic Withdrawal Plan
It provides investors with a specific amount of payout at pre-determined time intervals, like monthly, quarterly, half-yearly or annually. It can ensure fixed amount coming to the bank account on a fixed date just like salary income. The investor just has to invest a lump sum amount initially in a particular scheme or accumulate over the years via SIP. An SWP instruction is given to the mutual fund scheme.
Mutual Fund SWPs provide the assurance of getting a fixed amount at a pre-determined time frequency. In dividend options, frequency and/or payout of the dividend are not certain or fixed beforehand. Sometimes, if the scheme (with monthly dividend payouts) cannot generate sufficient profits, you may have no dividends to be paid. Hence every month you may have different amount coming in and some months there might be no money received. SWP has an edge in such a scenario.
In SWP, each withdrawal is a sale. With debt funds, withdrawals after three years will still incur capital gains. But since you will enjoy indexation benefit, it is likely that you will pay lower or nil tax based on the indexed cost. In case of equity schemes (including arbitrage schemes and equity savings schemes), long term capital gains on sale after a year of holding are exempt from tax. For equity schemes, dividend received is tax free and long-term capital gains on sale due to SWP is tax free after one year holding period. However, a dividend option puts control over the amount and periodicity of the returns in the hands of the fund manager.
For debt schemes, dividend attracts a dividend distribution tax @ 28.84%. However, after the holding period of three years, due to the indexation benefit, SWP is more tax efficient than dividend option for all tax slabs.
In equity schemes an investor could opt for dividend payout after ensuring the recent monthly payouts from the scheme are broadly in line with his requirements. In debt schemes, an investor should opt for SWP ideally after three years of investing to have the best of both worlds—monthly liquidity and tax efficiency.
The author is head, Retail Research, HDFC Securities