What Is Systematic Withdrawal Plan (SWP)?
Dividend plans of mutual funds made a lot of sense as long as the dividends were tax free in the hands of the investor. However, this benefit was withdrawn in two steps. Firstly, the Income Tax Act introduced dividend distribution tax (DDT) on dividends to be paid by the payer. This was tantamount to reduction of dividend. Subsequently, the dividends were made fully taxable two years back in the Union Budget resulting in no tax efficiency in dividends.
What does a person needing regular income from MFS do?
There is another answer called the systematic withdrawal plan. In a dividend plan, the fund in question can only pay dividends out of profits. This profits of the fund can either be in the form of interest/dividend received on the instruments or from capital gains on equity or debt. Both are uncertain. Now these dividends are also taxed at the peak rate.
One way out is to opt for a systematic withdrawal plan, where you create a corpus and gradually draw down the corpus via a systematic withdrawal plan or SWP. When you withdraw, there is a return component and there is a principal component in it. These become capital gains and hence are more tax efficient especially if they are long term in nature.
Is SWP something like a mutual fund SIP?
Let me put it this way. A systematic withdrawal plan is a mirror opposite of a systematic investment plan. An SIP is systematic investing, but what if you want to withdraw systematically? That is where systematic withdrawal plans (SWP) comes in handy. Instead of option for a tax-inefficient dividend plan, you can as well opt for systematic withdrawal plan.
Dividends can be only paid by mutual funds out of returns earned and not out of principal. These returns may be earned as dividends, interest or capital gains. That means; dividends are never assured; not even in debt funds. The other option is to structure a SWP to withdraw a fixed sum each month. While SIP is about regular investing to create corpus, the SWP is to gradually draw down the created corpus during retirement in a systematic way.
Is it correct that SWPS score over plain vanilla dividend plans?
That is bang on target. Systematic withdrawal plans give you predictable and tax efficient method of planning your flows. Here is how SWPs are better than dividend plans.
- First and foremost, dividends can be paid out of returns generated by the fund and not out of capital. That means there is nothing like assured dividends. On the other hand, SWPs are flexible as you can structure withdrawal of principal plus returns.
- You can plan your outflows better, structure it better and actually rely on it. For example, if your monthly cost of running your home is Rs.80,000, then you can structure SWP such that it pays you around Rs.80,000 on a consistent basis.
- SWP fits better into your long term financial plan. Long term financial planning is all about ensuring predictability of flows. Since, there is no predictability about dividends a better way of ensuring predictability is to opt for SWP.
- For retirees, SWPs can be a double advantage. Apart from giving you predictable income, it also gradually draws down your corpus. Once you have discharged your liabilities, there is no compulsion to leave any corpus. Instead, your use the SWP to tweak the corpus in such a way as to draw down fully over 20-25 years of lifetime.
- Finally, SWP are more tax efficient compared to dividends. Currently, dividends do not attract dividend distribution tax or DDT. However, the dividend income is fully taxable in the hands of the investor at the peak rate applicable. So, if you are in the 30% tax bracket, then your dividends will be taxed at 30% plus surcharge and plus cess. That is slicing away a big chunk of your earnings unnecessarily. SWP is part income and part withdrawal, so it works better from a tax perspective.
Can you explain SWP with a live example?
Let us take the case of a private sector official who retires at 60 with a corpus of Rs.2 crore. That may look large, but the official has to take care of her needs for the next 20 years. Here is how it would work.
- Problem statement: The official must invest Rs.2 crore in such a way as to pay for her maintenance costs for another 20 years.
- Estimates: It is estimated that she will need around Rs.100,000 per month through her retirement to lead a comfortable life.
- She cannot take risk as this is her only asset corpus and that needs to pay for her regular expenses for around 20 years.
- One way is to put the money in a liquid fund which yields a best case of 5% annually. Can that meet the expenses?
Let us assume she invests the entire Rs.2 crore in a liquid fund yielding around 5% annually. That will give an annual earning of Rs.10 lakhs per year as dividend or Rs.83,333 per month. That is lower than the income of Rs.1.00 lakh that the official is looking at. But, it gets worse if you also consider the tax angle.
There is also a tax angle to this When the liquid fund pays out Rs.83,333 per month as dividend, assuming you are in the 20% tax bracket after retirement, your net retention is just Rs.66,666. So in post-tax terms you are only now less than 70% of your monthly earnings.
How can systematic withdrawal plan resolve this problem?
Now, instead of putting it in a dividend plan of a liquid fund, you put it in a growth plan of a liquid fund and then plan systematic withdrawals. Here is how the Rs.2 crore corpus will be drawn down over 20 years. We are just showing annually instead of monthly, for simplicity, but you will get the hang of it.
| Year | Corpus in liquid Fund | Annual Interest income 5% | Annual Withdrawal via SWP | Closing Balance |
|---|---|---|---|---|
| Year 1 | 200,00,000 | 10,00,000 | 16,05,000 | 193,95,000 |
| Year 2 | 193,95,000 | 9,69,750 | 16,05,000 | 187,59,750 |
| Year 3 | 187,59,750 | 9,37,988 | 16,05,000 | 180,92,738 |
| Year 4 | 180,92,738 | 9,04,637 | 16,05,000 | 173,92,374 |
| Year 5 | 173,92,374 | 8,69,619 | 16,05,000 | 166,56,993 |
| Year 6 | 166,56,993 | 8,32,850 | 16,05,000 | 158,84,843 |
| Year 7 | 158,84,843 | 7,94,242 | 16,05,000 | 150,74,085 |
| Year 8 | 150,74,085 | 7,53,704 | 16,05,000 | 142,22,789 |
| Year 9 | 142,22,789 | 7,11,139 | 16,05,000 | 133,28,929 |
| Year 10 | 133,28,929 | 6,66,446 | 16,05,000 | 123,90,375 |
| Year 11 | 123,90,375 | 6,19,519 | 16,05,000 | 114,04,894 |
| Year 12 | 114,04,894 | 5,70,245 | 16,05,000 | 103,70,138 |
| Year 13 | 103,70,138 | 5,18,507 | 16,05,000 | 92,83,645 |
| Year 14 | 92,83,645 | 4,64,182 | 16,05,000 | 81,42,828 |
| Year 15 | 81,42,828 | 4,07,141 | 16,05,000 | 69,44,969 |
| Year 16 | 69,44,969 | 3,47,248 | 16,05,000 | 56,87,217 |
| Year 17 | 56,87,217 | 2,84,361 | 16,05,000 | 43,66,578 |
| Year 18 | 43,66,578 | 2,18,329 | 16,05,000 | 29,79,907 |
| Year 19 | 29,79,907 | 1,48,995 | 16,05,000 | 15,23,903 |
| Year 20 | 15,23,903 | 76,195 | 16,05,000 | -4,902 |
Here are the key takeaways from the above table.
- With the same Rs.2 crore corpus, you have structured an annual withdrawal of Rs.16,05,000. That translates into monthly withdrawals of Rs.133,750 per month.
- That is substantially higher than the monthly requirement of Rs.1 lakh. The official is now comfortable even if you consider the tax impact and inflation impact.
- At the end of 20 years, her corpus he totally wound down, but the surplus each month also gives her room to save something for emergency corpus.
- Once the 3 year period is completed, these withdrawals will become long term capital gains for the capital withdrawal portion, making it tax efficient.
The bottom line in the SWP model is that the corpus will last her till the age of 80, give her more to spend each month and also ensure that she pays out less as tax. SWP is like hitting multiple birds with one stone.