Make use of SWP in mutual fund to generate additional income

Couple of weeks back, I've used this space to explain on why and/or when to exit/sell a stock. Of course, I've argued about the need for a financial plan and sticking to it not only during investing phase but also during divesting period. I would like to use this article to check for an optimal way to exit the investments from a mutual fund (MF) ensure the gains and taxation are protected.

By now many of the investors are well-versed about the various staggered investment approaches i.e., through Systematic Investment Plan (SIP) and Systematic Transfer Plan. While the former is beneficial to divert the future income to investments to achieve rupee cost averaging, the latter is an ideal way to approach the same for an existing corpus to be deployed into investments, particularly to equity and related ones.

Rupee (Dollar) cost averaging is an approach where a particular amount of money is invested on regular intervals. The amount of money could be fixed and could also varied at a specified program to suit the need. Further iterations could be achieved by tweaking further in the way the amount is deployed within a range or extrapolated at a fixed variable. This is achieved by having to increase or decrease the installment/ contribution depending on the market parameters and at a pre-defined percentage of hike/cut respectively. These are the options achieved by the variable SIP.

The beauty of all this is the automation of the execution as once instructed which makes them attractive options of investing. Similarly, the STP is a mechanism where an existing corpus is parked in a debt fund and an instruction is given to be moved to another fund of destination. The interval could be daily to yearly depending upon the requirement making the investment to acquire the desired level of cost averaging. Most of this understood and is done by most investors.

The idea of the above strategies is to create large corpus to meet long-term goals. Even there many of the larger goals in terms of corpus amounts like children's education and retirement, tend to be staggered over a period of time unlike a wedding or a vacation where the proceeds are consumed at one-go. Especially for retirement, the corpus built over a period is consumed for a much longer period than of the investment. So, by redeeming or withdrawing the entire corpus, the purpose is unachieved and likewise for a constant cashflow requirement, one can't be issuing multiple redemptions in each year. To bring the automation into that aspect of inflows, one could rely on the Systematic Withdrawal Plan (SWP). It's a structure or instruction where the investors could determine the amount and the interval of redeeming a fund. This creates for much needed cash or liquidity at a desired interval replacing the non-existent income. In some cases, this could be a supplementary or a secondary income easing the cashflows for an individual. A further tweak in this plan is to only withdraw the gains while retaining the initial investment which further participates in the investment journey. For instance, if a MF investor after having created a large corpus decides to bring in regular income during his/her retirement, one could issue a monthly or a quarterly SWP depending on the requirement which automatically withdraws the defined amount at that interval. As most of the times, the markets (equity) remain volatile, it's hardly likely to have the same NAV (Net Asset Value) of the fund at each interval. This as the SIP in investing, would average the sale price of the assets. So, if for instance at one withdrawal happens at, say, 10/- NAV, the next could be at 9.5 and the other at 10.5. For discussion's sake, assuming a total of 10,000 units and the investor looking to withdraw a fixed amount of 1,000 per interval then the units deducted are 100, 105 and 95 respectively. This could continue as long as the units last or the instruction ends, whichever being earlier.

Another advantage of this approach is that it gives a feel of regular income which one was earlier habituated during their working life and also gets into a disciplined spending or routine. Though, the overall corpus value varies with the market volatility, the net outflow on each interval would remain same giving a sense of peace and comfort to the investor. An alternative is to use dividend scheme of the same fund to get a lumpsum in the form of regular dividends. This of course, has turned unattractive due to the taxation deduction at source (TDS) over the dividends of MF units.

While we've witnessed the cost averaging of the SWP, the taxation could also benefit this approach of withdrawal. The long-term capital gains (LTCG) of equity and aggressive hybrid funds is 1 year with a tax of 10 per cent without indexation while the short-term rates (i.e., less than 1-year) are at 15 per cent. In a debt or conservative hybrid fund, the LTCG is as 20 per cent with indexation for a period of three years and above while that of the short-term is anything less than is taxed at the individual tax limits.

The lack of TDS in SWP also scores better over the dividend taxation even in the short-term gains where the individual's taxation is nil or have gains that could be offset. This flexibility and convenience have helped it to retain as the best income generating option through corpus. A word of caution, however, is to not go with the past performance reports as the near-term stock market returns are on an uptick and could give a false sense of comfort. These could be ideal in a bull market phase but a long period of application would iron out the volatility over the cycles. Any open-ended scheme could be used for this approach for creating an alternative tax-efficient income source.

(The author is a co-founder

of Wealocity, a wealth management firm and could be reached at [email protected])