Why SWP
- Ensures regular cash flow
- Reinvestment risk in FD can be overcome with SWP in debt funds
- Tax paid is significantly lower than tax on FD interest
- With some planning, can grow corpus apart from generating monthly cash flow
Dividends are not a prudent or efficient way to get regular income from mutual funds. We explained in our article why systematic withdrawal plans (SWPs) are better than dividend payouts in debt funds. In this article we explore why investors looking for regular income should consider SWPs instead of entirely locking into FDs alone.
Systematic Withdrawal Plans (SWP) let you make periodic redemptions from your investment. Like in an FD, where you can opt for monthly or quarterly payout of interest, you can set SWPs for the period. This way, you will be able to make regular income out of your mutual funds without depending on the scheme to declare payouts for you.
Bank Fixed Deposits (FDs) are a common option among investors who want the comfort of assured cash flows. But its low risk counterpart in mutual funds (ultra short and short term funds) are often overlooked.
Changing returns but stable income
In the case of FDs, the returns from your investment is the interest rate you get locked in to. Debt funds returns depends on the performance of the fund during the period. The reason why your first choice remains FD is because of the fixed return and stable income. While debt funds do not provide fixed returns, you can generate fixed cash flows from them. And more often than not, the effective return you get from a SWP in debt funds is much more than FDs. With an illustration, we’ll show you how.
The table compares a 5 year FD with ultra-short, short and medium-term debt funds. The example assumes the investment was made five years ago, in February 2013. The highest prevailing interest rate then, with bank deposits, was 9%.
Superior taxation
As seen from the table, the taxes paid under the SWP option is often just 10% of the tax you would have paid on an FD. As a result, the post-tax return of debt funds under SWP looks better.
Interest income from FDs is taxed at the income tax slab of the individual. For debt funds, the gains are taxed at the time of redemption. Depending on the duration held, capital gain tax can be short term or long term. Short term capital gain tax, for units less than 3 years old, is taxed at the tax slab. Long term capital gain tax is taxed at 20% after cost indexation.
The tax benefits of debt funds have a tremendous impact on the effective returns. The difference primarily comes from the fact that in debt funds only the gains are taxed. That means, when you redeem, only the growth over the capital is taxed. Withdrawals in the initial years, which are subject to short term capital gain tax, will have less of gain component and more of capital. And in the later years, you get indexation benefit with long term capital gains. This results in the tax outgo being significantly lesser for the same investment amount.
For those of you in the 30% tax slab, going with SWPs will clearly leave you better off because the tax is eating up much of your interest. The reason the returns for lower slabs are closer to FDs is because of locking in to a high rate of 9% (In the next section,we will see how you may not always get this lucky!). Even then, the effective returns are higher in case of SWPs.
Reinvestment risk in FDs
Banks keep varying their FD rates and that poses a risk to your investment. The graph below shows historical FD rates. A rate of 9% is not only the highest rate offered five years ago but also one of the highest interest rate levels over the past decade.
Locking into a high rate scenario, no doubt helped you. But what if the opposite happens? Prevailing rates are on the lower levels at 6.25% – 7%. If the rates go up in future, you will not be able to take advantage of it.
Also, if you had opted for a 3 year FD or a 1 year FD and went for renewal, the entire scenario would have been different. You would have had to renew at prevailing rates which were much lower than your original rate.
What are we saying here? Volatility exists in FDs as well, though not as explicitly as in debt funds. Returns may be fixed with FDs. But what look attractive now may not look good five years down the line when rate (and inflation) scenarios are entirely different.
Debt funds do the job of generating inflation beating returns along with being the most tax efficient option. Setting up SWPs are as easy as opening a fixed deposit. It is also a one-time process but with an added flexibility of auto-adjustment of rates without you trying to time interest rates. Here are a few rules you will need to be aware of when doing SWPs:
- If you are a senior citizen, you should first consider options such as Post Office Senior Citizens’ scheme and use SWP under debt funds only as a diversification. PO Senior Citizens’ scheme offers better rate than FDs. Also, as a senior citizen, interest income from your deposits will be exempt upto Rs 50,000 a year effective FY-19. Hence make use of this first and then move to SWP.
- If you need immediate income from your corpus, you should stick to liquid/ultra -short/short-term debt funds. Going for SWP in long-term debt funds could mean volatility of capital in the short to medium term. You don’t want your income generation to be affected by such volatility. If you have a large corpus, then allocate a chunk to short tenure debt funds. Add long-term debt funds such as income funds but use them for SWP only after 2-3 years post investment thus giving them some time to grow and provide cushion against volatility.
- The ideal way to withdraw is to redeem whatever amount you need every month. However, if you are particular that you should not deplete your corpus or want your corpus to last longer, them your annual withdrawal rate should be lower than the realistic long-term returns from that fund. For example, if a fund has delivered 7.5% annually in the past 3-5 years, then you will do well to keep your annual withdrawal to 6.5-7% of your corpus to ensure the corpus stays intact and also grows.
If you are saddled with too many loans, go through this road map for a debt-free future
2. Prioritise your debt repayments moving from the costliest loans to the cheapest, the normal ladder being:-
a) Credit card payments, being most expensive at 35%+ interest a year.
b) Personal loans, holidaying loans and festival loans, with 18%+ interest a year.
c) Consumer durables loans, with 15%+ interest a year.
d) Vehicle purchase loans, with 12%+ interest a year.
e) Education loans, with 12%+ interest a year, but with tax benefits on interest.
f) Home loans, with 11-13% interest a year, but with tax benefits on principal and interest.
3. If credit card dues have become huge, ask bank to convert it into a personal loan, for paying them through 6-24 EMIs, as its interest will be far lesser than when rolling over the balance.
4. If there is a cash crunch, taking a cheaper loan against your assets as collateral, to repay costlier debt, is better, provided you are disciplined, such as:-
a) Property, at 50%+ value, with 16%+ annual interest.
b) Gold, at 65%+ value, with 12%+ annual interest.
c) Shares, mutual funds and securities, up to 50% value, at 18%+ annual interest.
d) Insurance policies/Ulips, at 50%+ value, with 16%+ annual interest.
e) PPF, up to 30% corpus, at 2% rate above your PPF earning rate annually.
5. You can also liquidate:-
a) Low-yield investments or gold holdings, to pay-off high-cost debt whose recurring interest is higher than returns from them.
b) Non-performing mutual funds and loss-making shares to clear-off debt on priority.
6. If you want to effectively cut down on your debt, you also need to make some lifestyle changes by reducing discretionary expenses like family outings, phone and electricity usage, car expenses, etc., without compromising on mandatory expenses like children’s school fee, basic food and living expenses.
7. If mounting debts and unpaid EMIs are unmanageable, you can seek professional help of debt “de-addiction” centres, having debt counselors, who can guide you towards a solution, by examining all options to suggest most feasible ones.
8. Modern ones also offer a long-distance tech solution, by interacting through e-mail, phones and chats.
9. However, beware of conmen who will promise to get your dues settled for a small fee, but will adopt unethical practices spoiling your credit report in the process.
10. As a thumb rule, for comfortable debt, your EMIs of all loans put together should not exceed 30% of your net income, or 40% max. if your first home loan is the only loan.