The working of a Systematic Withdrawal Plan (SWP)
The Finance Ministry, in its budget for FY 2020-21, abolished Dividend Distribution Tax (DDT) on income distributed by mutual funds. In the erstwhile regime, the tax on dividend was paid by the mutual funds as DDT, and dividend therefore was received tax free in the hands of the investor. Post the budget amendment abolishing DDT, dividends received from 1st April 2020 will be taxed in the hands of the investor.
This has several important implications for the individual investor. In the earlier regime, dividend options were used by investors to receive periodic cash flows. However, with dividends set to be taxed in the hands of the investor at marginal rate of taxation, it may not be ideal to use this mechanism for receiving periodic cash flows by the investors in the higher tax brackets, considering the fact that DDT was 11.648% (including surcharge and cess) for equity oriented schemes in the erstwhile regime.
On the other hand, a SWP would be a better alternative to receive periodic cash flows. Although, withdrawing a fixed amount every month from the growth option of a scheme may lead to capital gains to the investor, the gains may be taxed at lower rates (depending on the applicable marginal rate of taxation) compared to dividend income:
- For equity-oriented mutual funds, short term capital gains (period of holding less than 12 months) are taxed at 15%. Long term capital gains (period of holding more than or equal to 12 months) are exempt up to Rs. 1 lakh, and taxed at only 10% thereafter.
- For debt oriented schemes, although short term capital gains (period of holding less than 36 months) are taxed at the investors tax bracket, long term capital gains (period of holding more than or equal to 36 months) are taxed at 20% with indexation.
More importantly, the tax impact is reduced in an SWP, where an investor receives monthly cash flows. Here, a certain amount of units are redeemed at the prevailing NAV depending on the amount chosen to be withdrawn. From the taxation perspective, the amount withdrawn includes a principal component and an appreciation component and the capital gains tax is applicable on the appreciation component.
For example, if one SWP instalment is Rs. 100, and the capital gain component within it is say Rs. 10, long term capital gains would be 10% on Rs. 10, or Re. 1. This is just 1% of the withdrawn amount of Rs. 100. However, in case of a dividend of Rs. 100, tax on that dividend would be applied on the entire Rs. 100, in accordance with the investor’s marginal tax rate.
Therefore, an SWP may now turn out to be a more tax efficient option of ensuring a steady cash inflow for the investor, compared to dividends.
Sources:
Various publications
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