To generate a regular passive source of income, you could opt for a Fixed Deposit with monthly payout, you could go for a Bank Monthly Income Scheme, you could also opt for debt based mutual fund providing monthly income (MIP), and you could even go for a regular equity based mutual fund investment using SIP and then withdraw using SWP.
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(Recommended Read --> 7 Income Streams of most millionaires)
(Recommended Read --> 5 Simple Strategies to make your SIP work harder)
FDs and Bank MIPs are not tax efficient, and we are not looking at those options in this post. Today, we are comparing two of the most profitable options ie MIP based Debt Funds (referred to as MIP in this post) or regular equity funds and using their SWP strategy to withdraw funds at regular intervals (called as SIP in this post)
What is MIP?
An MIP is a debt mutual fund scheme which invests a small part of the funds (15-25 per cent) in equities (any mutual fund scheme that invests less than 65% in equities is a debt based mutual fund scheme). It offers regular income in the form of periodic (monthly, quarterly, half-yearly) dividend payouts.
What is SWP?
A Systematic withdrawal plan, or SWP, is a money withdrawal strategy (just like an SIP is a money investment strategy) which allows regular redemption of a pre-determined amount from the mutual fund balance (any mutual fund, whether debt or equity) that you are maintaining.
The SWP strategy wins hands down over the MIP strategy, though MIP looks more beneficial since it does not seem to reduce your principle amount in the fund when providing dividends.
Let us analyse the two strategies across various parameters:
Surity of Payout
In a MIP scheme, dividend is paid at the discretion of the mutual fund house. The payouts depend on the availability of surplus cash. Even under MIPs which promise regular dividend, it is not mandatory for mutual funds to pay at stated intervals. Since MIPs invest 15-25 per cent funds in equity, many fund houses fail to pay when stock markets are falling. This is because, by the very nature of MIP, only the capital appreciation portion is distributed, while the principle always remains untouched.
In SWP option, the withdrawal is always of the fixed amount, irrespective of the fund performance, thus making sure that your monthly requirements are met. Opting for a systematic withdrawal plan (SWP) reduces the risk of irregular cash flow. Even when the scheme is making losses, it will pay the amount opted for by the investor by digging into the principal, if needed.
Dividend Distribution Tax (DDT)
The dividend paid by MIP funds is not taxed in the hand of investors, but a dividend distribution tax (DDT) has to be paid by the mutual fund company. A DDT of 12.5 per cent (excluding education cess and surcharge) is deducted from the dividend paid by debt funds other than liquid and money market funds. Therefore, all dividends under MIPs are paid after DDT deduction, thereby reducing your dividend yield by that much amount.
In SWP, there is no dividend or any DDT thereof.
Long Term Capital Gains
Long-term capital gains are taxed at 20% after indexation adjustment for MIP debt based funds.
For SWP, the long term capital gains taxes are 0%. Smart investors go for systematic withdrawal after one year of investing.
For MIPs, Long Term Capital Gains start after 3 years. Any capital gains realised prior to that is considered short term and taxed as per your current tax slab.
For SWP, Long Term Capital Gains start after 1 year.
Summary
Dividend Distribution Tax (DDT)
The dividend paid by MIP funds is not taxed in the hand of investors, but a dividend distribution tax (DDT) has to be paid by the mutual fund company. A DDT of 12.5 per cent (excluding education cess and surcharge) is deducted from the dividend paid by debt funds other than liquid and money market funds. Therefore, all dividends under MIPs are paid after DDT deduction, thereby reducing your dividend yield by that much amount.
In SWP, there is no dividend or any DDT thereof.
Long Term Capital Gains
Long-term capital gains are taxed at 20% after indexation adjustment for MIP debt based funds.
For SWP, the long term capital gains taxes are 0%. Smart investors go for systematic withdrawal after one year of investing.
For MIPs, Long Term Capital Gains start after 3 years. Any capital gains realised prior to that is considered short term and taxed as per your current tax slab.
For SWP, Long Term Capital Gains start after 1 year.
Summary
In general, SWP scores over MIP strategy on most fronts. However, SWP works better when a person has invested and accumulated a significant sum (with respect to the withdrawal one is seeking). In a small investment, if the return generated is less than the regular payouts, it will fast erode capital. In such scenarios, MIP is the only way out.
Cheers
Manoj Arora
Life elevating books :
Interesting article. I have a question: Is there any reason why a broker will recommend Dividend MF against SWP MF? Does he get more income from the former?
ReplyDeleteBrokers are aligned to recommending Dividend MFs in most cases because it ensures that you stay invested and continue to invest. In SWP, there are higher chances that you might move out your investments if you tend to increase the SWP amount because of personal reasons.
DeleteMore than the broker, it is the need of the investor that decides which strategy to use.
Regards
Manoj