Many of us are familiar with Systematic Investment Plans (SIPs), where you invest a fixed amount every month in mutual funds in order to generate a corpus over the long term.
However, not many are aware of a closer cousin Systematic Withdrawal Plans (SWP). SWP is the opposite of SIP. In SIP, you invest small amount every month to create a corpus. Under SWP, you systematically withdraw from the corpus to generate regular income.
In this post, let’s find out more about SWPs and how SWP should be used to generate regular income.
What is a Systematic Withdrawal Plan (SWP)?
In a SIP, you invest a fixed amount in a particular MF scheme on a fixed date every month.
In case of SWP, you do exactly the opposite. On a specific date every month, a few units are automatically sold (redeemed) from your holdings in a MF scheme. You decide the amount that you want to receive every month. The number of units to be redeemed is automatically calculated based on the NAV on SWP date.
For instance, if you own 10,000 units in a particular MF scheme and have set up a systematic withdrawal plan of Rs 10,000 for 15th of every month.
Every month, a few will be redeemed on 15th and the redemption amount will be credited to your bank account.
Your holding in the MF scheme will go down by the number of units redeemed.
I have chosen frequency as Monthly. You can choose frequency as weekly, quarterly or annual too.
Benefits of Systematic Withdrawal Plans
If you want regular income, SWP is an option worth exploring.
If you invest in fixed deposit or an annuity scheme for regular income, the interest income or annuity payment is taxed at your marginal income tax rate.
However, in case of SWP, your income is on account of redemption of units. Hence, capital gains taxation will apply.
And capital gains taxation can be favourable if you have held the units for long term.
Long term capital gains tax on equity mutual funds (> 1 year) is Nil while it is 20% after indexation for debt mutual funds (> 3 years). Short term capital gains tax on equity funds is 15% while short term gains on debt funds are taxed at marginal income tax rate.
If the units sold under a SWP in a debt mutual fund have been held for more than 3 years, you will get beneficial tax treatment.
Hence, you can save income tax by planning SWPs smartly.
What are the issues with Systematic Withdrawal Plans?
In a falling market, more units will have to be redeemed to generate same level of income. This can be a serious problem, especially for a retirement portfolio.
You have to redeem more number of units in a falling market.
It is also evident from the above example. When the NAV is 100, only 100 units are redeemed. A few months later, when the NAV is 65, 153.8 units are redeemed.
Thus, in a falling market, your portfolio will deplete much faster. In a bear market, SWP in an equity fund can be a disaster.
Therefore, you must avoid setting up a Systematic Withdrawal plan (SWP) in an equity scheme.
If you are looking for regular income through SWP, it is better to set up SWP in a debt MF scheme. Debt mutual funds are not as volatile.
How should I plan?
Avoid SWP in equity or balanced funds.
Your approach should be to move from equity funds to debt mutual funds as you move closer to your retirement (or the time when you have to set up SWP to generate regular income).
Plan it in a way that your redemption under SWP are eligible for long term capital gains tax.
Subsequently, set up SWP in a debt fund (or a debt hybrid fund).
The post was originally published on June 13, 2016.