For many years, mutual fund investors relied on dividends as a source of regular income. The main reason for that was that mutual fund dividends from equity-oriented schemes were not taxed when received by the investor. This changed in the latest budget where dividend income from mutual funds is now taxable at the rate of your income tax.
It is no longer efficient for investors, especially those in the highest tax bracket to opt for the dividend option. In the other alternative, which is the growth option, there is no automatic route for regular income, however, you can create a regular income structure through systematic withdrawal plans or SWPs.
As opposed to the systematic investment plan or SIP which allows you to invest in small amounts on a regular basis, an SWP allows you to withdraw defined amounts in regular frequency. Just like your investment, the withdrawal is also defined as per your convenience. However, there are certain things you need to be careful about before jumping into this facility.
Starting an SWP from an equity investment made 10 years ago is a lot more sensible because you know there is a lot of accumulated gain in that and you can then use those gains as your investment income on a regular basis.
An accumulated corpus
To afford a regular income in the form of SWP, ideally, you should have an accumulated corpus in mutual funds before you begin. What this means is, if you invest a lump sum today and start an SWP in the next month from this amount, in all likelihood you will start withdrawing your capital.
This happens because the money you invested hasn’t had any time to grow. Starting an SWP from an equity investment made 10 years ago is a lot more sensible because you know there is a lot of accumulated gain in that and you can then use those gains as your investment income on a regular basis.
Be mindful of taxation
Just like each SIP is treated as a separate investment, each SWP is also a separate redemption and hence, the tax treatment will be different too. For example, any capital gains in an SWP started in a debt fund after two years of investment, will be treated as short term capital gains. However, if the SWP continues for more than a year and goes beyond the third year, any gains will be treated as long term capital gains.
You have to be aware of the capital gains tax status for each withdrawal.
How much to withdraw
You may have a large enough accumulated corpus, but how much should your SWP amount be? Ideally do not withdraw more than what the yield of your investment is. If you start withdrawing monthly amounts in excess of what you can potentially earn in the scheme, your corpus will start to decline at a faster pace than it is growing.
Over time, assuming that the SWP continues at the same rate, you may end up withdrawing and depleting capital. Setting this up can get tricky because, equity mutual funds are market-linked investments, and the returns are assumed rather than fixed.
This is why the first point is important. Especially in equity schemes, the growth is nonlinear, in one year you can make a hefty return and in another a loss. If you have accumulated gains, you needn’t stop your SWP in a year that equity returns were poor. At the same time, you should not increase the withdrawal amount in a year of extraordinary gains.
Estimate what the annual average return or yield of the fund is likely to be, break that up into 12 equal parts and set your monthly SWP around 20% less than that figure. It could be 10% less or 30% less too, depending on your specific requirements.
Make use of the SWP facility if you need regular income, but be mindful of these factors else it will end up doing your investment more harm than good.