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Dividend or Systematic Withdrawal? Puzzle Cracked!

The regular readers of this blog would remember my earlier post on this subject viz. Systematic Withdrawal From Mutual Funds Far Superior To Dividends.

Just to recap:
- You have two options to receive regular income from your investment in mutual funds (especially debt funds) namely Dividend or Systematic Withdrawal Plan (SWP)
- As explained therein, SWP is a far better option to earn periodic income, as compared to receiving dividends.

[Unaware of SWP? Simple... it is nothing but redeeming part units at every interval, based on the regular inflow desired. It is the facility provided by MFs, wherein a pre-fixed amount is automatically returned to you — by selling your units — at pre-decided intervals like monthly or quarterly.]

One of the key advantages of SWP is the assurance of a "fixed" inflow. Dividends, on the other hand, will most probably "vary" depending on the profits generated by the scheme.

The second key advantage of SWP is that you pay far lower tax as compared to dividend option. So, with SWP you get more post-tax cash in hand.

However, many investors are not convinced by this. They feel that as they regularly redeem their units, the value of their investment will keep falling and some day become zero. Whereas under dividend option their capital will remain intact forever.

Well, intuitively this may seem to be true:

But the reality is not so!

Let's take a live example and see for ourselves why we would be far better off with systematic withdrawal plan vis-a-vis the dividend option.

Points to be noted:
1. I have taken actual five-year data for one representative scheme viz. HDFC Income Fund.
2. For like-to-like comparison, I have assumed that the investment is redeemed after five years.
3. Tax on Dividend is 25% (+ surcharge + cess). 
4. Tax on Short Term Capital Gains (less than 3 years) is your slab rate say 30%.
5. Tax on Long Term Capital Gains (more than 3 years) is 20% with indexation benefit.
6. To keep the calculations simple, I have ignored (a) additional cess and surcharge on dividends and (b) the benefit of indexation on LTCG. (As you will appreciate, this will further increase the difference in total tax payable under the two options.)

Case 1 : Dividend Option
Scheme : HDFC Income Fund - Quarterly Dividend
Date of purchase : 01-01-2013
Amount invested : Rs.4,00,000
NAV (on 01-01-2013) : 11.2979
Units Allotted : 35,404.81

Here's what you will get under Dividend Option.

mf-dividend-option

After 5 years
NAV (on 26-12-2017) : 10.9535
Redemption Value : Rs.3,87,807 (= 35,404.81 * 10.9535)
Capital Loss : Rs.12,193 (= Rs.3,87,807 - Rs.4,00,000)
Tax on redemption (@20%) : Nil

Summary
Total Dividend Received = Rs.1,19,491
Total Tax Paid = Rs.29,873
Redemption Amount = Rs.3,87,807


Case 2 : Systematic Withdrawal Plan
Scheme : HDFC Income Fund - Growth
Date of purchase : 01-01-2013
Amount invested : Rs.4,00,000
NAV (on 01-01-2013) : 26.4718
Units Allotted : 15,110.42
SWP assumed : Rs.6000 / quarter (so that total inflow matches with total dividend recd.)

Here's what you will get under Systematic Withdrawal Plan.

mf-systematic-withdrawal-plan

After 5 years
NAV (on 26-12-2017) : 38.1672
Balance Units : 11,345.58
Redemption Value : Rs.4,33,029 (= 11,345.58 * 38.1672)
Capital Gains : Rs.33,029 (= Rs.4,33,029 - Rs.4,00,000)
Tax on redemption (@20%) : Rs.6606

Summary
Total Amount Withdrawn = Rs.1,20,000
Total Tax Paid = Rs.11,354 (= Rs.4748 + Rs.6606)
Redemption Amount = Rs.4,33,029

Hence, 
a) The investor paid much lower tax under SWP vs Dividend Option. 
PLUS
b) SWP gave higher value at redemption due to small compounding effect.

Concluding: Systematic Withdrawal Plan is superior to Dividend Option.

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