Mutual Fund investors invest mainly with one key objective in mind – making their wealth grow over time. But there can be two key ways of achieving this goal. While some investors seek to stay invested in the long term with the aim of booking gains at a later date, others prefer a regular influx of money while they stay invested in their chosen scheme. Hence, investors have to make the choice between opting for the growth or dividend option of mutual funds. In the following sections we will discuss the implications of this choice to help you decide why growth option with systematic withdrawal plan (SWP) outshines the dividend option. But firstly let’s briefly discuss the concept of SWP.
Systematic Withdrawal Plan – The Smart Method of Unit Redemption:
If you are a seasoned investor you probably realise that timing your redemption of mutual fund units is as important, if not more than timing your entry into a scheme. This holds true even if you are investing via the SIP (systematic investment plan) which allows you to average out the cost of unit purchase over time. Luckily there is a way to avoid this problem altogether – go for a reverse SIP also known as a systematic withdrawal plan (SWP). The concept is simple – once you have completed your scheme investments and wish to redeem your units, you choose to redeem units a few at time instead of doing the traditional lump sum redemption. Typically a SWP can be configured to either redeem a specific number of units periodically or withdraw a specific amount at predetermined intervals till your entire investment has been redeemed. In both cases, your redemption value is automatically transferred to your registered bank account at the end of each withdrawal.
The benefit of the system is obvious – while your chosen scheme’s NAV may remain volatile in the short term, your withdrawal will be completed based on the average NAV of the scheme over the tenure of the SWP. So using the systematic withdrawal method, you will receive the benefit of rupee cost averaging even at the time of redemption while ensuring a continuous influx of money.
The Problems with Dividend Option of Mutual Funds:
Dividend option of mutual funds, though considered to be a good option for those seeking a source of regular income while staying invested in their chosen scheme do have a few problems. For one, the scheme needs to have a distributable surplus in order to make dividend payouts. Hence if market conditions are not conducive, no dividends can be paid out by the scheme. Additionally, the fund management takes the final call even if there is a surplus available and the decision might be taken not to make dividend payouts even if a distributable surplus is available. Thus, if an investor such as a retiree is dependent on dividend payouts as a regular income source, they might face issues related to fluctuating income levels by opting for the dividend option of mutual funds.
The Taxation of Dividend vs Growth Option of Mutual Funds:
When it comes to taxation of mutual fund dividends, the good news is – you do not need to worry about an increase in tax liability by opting for a dividend scheme. To put it another way, any dividends you receive are completely tax free once in your hands, however they are subject to DDT i.e. dividend distribution tax. DDT is payable directly by the mutual fund company to the tax authorities but it does impact your overall returns through an increase in the expense ratio of your scheme. Till Budget 2018, dividends from equity mutual funds were completely tax free, however now DDT applicable to equity investment is 10%. This amount is even higher in case of debt schemes where the DDT charged is 25% plus applicable cess on any and all dividends distributed by your debt fund. This obviously decreases your overall potential returns received through dividends over the long term.
How SWP works out as a more Tax Efficient Alternative to Dividend Option:
If you initiate a systematic withdrawal after having held your equity mutual fund investments for at least one year, you will have to pay the 10% tax on gains only if total gains from redemption exceed Rs. 1 lakh during the financial year. Mathematically even if you have managed 25% returns (an almost impossible feat), you will have to redeem units worth Rs. 5 lakhs annually on an initial investment of Rs. 4 lakhs in order to breach this tax free limit. That brings your SWP redemption to an excess of Rs. 40,000 months – a largish amount to say the least unless you are a HNI. Even then, the first Rs. 1 lakh of gains will be tax free, while every rupee earned as dividend will be taxable. So for long term equity investors, SWP offers more lucrative post tax returns as compared to dividend option of the same plan.
In case of debt investments, an SWP done after completion of 3 years from the date of initial allotment will incur tax at 20% of gains adjusted for inflation i.e. with indexation. By applying indexation benefits, investors are able to decrease the applicable taxes – obviously a beneficial outcome. What more even if the benefit of indexation is not considered, the 20% tax applied on gains still turns out to be less than the 25%+ in DDT applicable to dividends distributed by a debt scheme. Hence even in case of debt funds and other non-equity schemes, SWP provides superior tax benefits as compared to the dividend option of the same scheme.
Ensuring Consistent Income through SWP:
As discussed earlier, dividend payouts may turn out to be inconsistent in nature due to changing market conditions as well as tactical decisions made by the fund management. In case you have set up an SWP for a specified amount instead, your payouts will remain the same over your chosen tenure. The only change will be the number of units redeemed in each case based on the applicable NAV of your fund. Hence, opting for a SWP over a dividend payout provides the dual benefit of consistent payouts and tax efficient investment returns in the long term.