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Systematic Withdrawal From Mutual Funds Far Superior To Dividends

If your aim is to receive "regular income" from your debt mutual funds, you have two choices.

You can either choose the Dividend Option.

Or, you can automatically redeem part units every month, based on the regular inflow desired. (This process is known as Systematic Withdrawal Plan or SWP. It is the facility provided by MFs, wherein a pre-fixed amount is periodically returned to you, by selling your units at pre-decided intervals like weekly, monthly, quarterly, etc.)

As discussed below, SWP is a far better option to earn periodic income, as compared to receiving dividends.

1. Receive Assured Inflow

Dividends declared by mutual funds are subject to the profits earned by the scheme.

Of course, unlike equity funds, debt mutual funds earn fairly safe and stable returns. Hence, it is possible for debt mutual funds to distribute steady dividends at regular intervals.

Having said that, we also know that the mutual fund returns are market linked. As such, if for some reason, there is a dip in the profits then the dividend distributed may also be lower in some months.

Whereas your monthly expenses would more or less be fixed. In such a scenario, receiving lesser dividend in a particular month could affect your cashflows.

You can avoid this problem by (a) choosing the Growth Option and (b) fixing beforehand how much amount you wish to receive every month. Accordingly, on one hand the NAV of your scheme will keep increasing. On the other hand, mutual funds will redeem the required number of units and credit the equivalent amount to your bank account.

[In other words...
... in Dividend Option, the profits are distributed as dividend. So the NAV remains more or less constant. Since the units are also constant, your total capital remains more or less the same. 
... in Growth Option, your total units reduce as part units are redeemed every month. However, as the NAV is increasing, AGAIN your total capital remains more or less the same (depending on your monthly payout amount). Normally, for reasonable sums there is NO reduction in the capital, despite part units being redeemed every month.]

Thus, Systematic Withdrawal Plan gives you an assured inflow. Whereas dividends could sometimes vary.

Systematic Withdrawal Plan gives more (post-tax) cash than Dividends.

2. Pay FAR LESS Tax 

On dividend payout, 28.84% (=25% DDT + 12% Surcharge + 3% Cess) is deducted as Dividend Distribution Tax.

And, this is irrespective of your income tax bracket. Even if you fall in the Nil tax bracket, you still end up paying 28.84% as tax if you take your income in the form of dividends.

This is where Systematic Withdrawal Plan proves to be an extremely tax efficient alternative.

Since SWP involves redemption of units, your returns are in the form of "Capital Gains".

For taxation purposes, capital gains on debt mutual funds are classified as 
- Short Term Capital Gains if the holding period is less than 3 years, and
- Long Term Capital Gains when the holding period exceeds 3 years

(a) Tax On Short Term Capital Gains
Short term capital gains are added to your total income and taxed as per your marginal income tax slab rate.

So, after adding the short term capital gains, if say you still come under the Nil tax bracket you pay nil tax. Likewise, if you come under 10%, 20% or 30%, you pay tax accordingly.

As you can see, tax payable on short term capital gains is far lower than the tax on dividend, if your income tax bracket is Nil, 10% or 20%.

For the investors in the 30% bracket, it appears as if they are liable to pay slightly more tax on short term capital gains than dividends. But that is not the case!

Remember, when the units are redeemed, part of it is principal and part profit. So the 30% tax is payable on the 'profit portion' only. Whereas under dividend option, 28.84% is payable on the entire amount. Thus, the actual outflow of tax under Systematic Withdrawal is dramatically lower than under Dividend Option. [Similarly, net tax payable under 10% and 20 tax bracket is also much (much) lower.]

(b) Tax On Long Term Capital Gains
Long term capital gains is taxed @20% (+ 3% cess and surcharge, if applicable) with indexation benefit.

In the worst case scenario, let's assume that the impact of inflation is nil and indexation benefit is zero. Then, the maximum tax liability is 20%.

Normally there will always be some inflation. So the effective tax rate would be less than 20%. Plus, as mentioned earlier, only the profit portion is taxed, not the principal portion. This slashes the tax outgo significantly.

Hence, for investors in 20% or 30% tax bracket, systematic withdrawal plan is a far better option compared to dividends (and also fixed deposits, where the tax payable on interest income would be 20% or 30%).

If you are in the Nil or 10% bracket, even then SWP is far superior to dividends. However, the advantage of tax efficiency over FD interest is lost. Consequently, investors in the Nil or 10% tax bracket can probably continue with the good old Bank Fixed Deposits.

Concluding: Systematic Withdrawal Plan enables you to earn regular income from your debt mutual funds with much lower tax liability compared to receiving divided income. Therefore, forget dividends and take home more post-tax income with systematic withdrawal plan.

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