This article, second of the two articles on the subject, explains two important features of SWP:
- Tax benefit, and
- Impact of NAV fluctuations on the withdrawals
Happy reading ...
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English translation is as under:
Last time, we talked about a convenience offered by mutual funds for
those seeking regular income. In that article, we also mentioned the following
words of caution: “… please consider this discussion only in the context of
liquid and short-term debt funds and no other categories. “
Why is such a caution required? To answer this question, we have to
understand how mutual funds work.
A mutual fund is a pooled investment vehicle, which means small
amounts are pooled from a large number of investors to create a big corpus. This
means, there could be differences between the investment horizons of various
investors. Some may invest for a short period, while some may invest for a
longer time.
One of the benefits of investing in open-ended mutual funds is the
liquidity – any investor can enter the scheme or get out of it on any working
day. However, this also means that at all times, there could be three different
categories of investors: (1) those entering the scheme, (2) those exiting the
scheme and (3) those old investors staying with the scheme.
It is also important to ensure that all the investors get a fair
price at all times. This is why the buy and sell transactions in a mutual fund
scheme happen at NAV – the Net Asset Value, which is calculated in a
transparent and fair manner to be as close as possible to the realizable value.
This NAV is a function of the market value of securities in which
the fund has invested. These market prices may fluctuate on a daily basis. Due
to this, the mutual fund schemes witness fluctuations in the NAVs.
It is important to understand the above in order to understand why
we recommended SWP of fixed amount in a liquid or ultra-short term fund. These
categories of funds exhibit very low NAV volatility.
Now, let us go back to the basic objective behind setting up a SWP –
it is for an investor who is seeking regular income from the investments. These
regular withdrawal transactions, as we saw earlier, happen at the NAV linked
prices. Let us see what happens in the below mentioned hypothetical case:
Sr
|
Amount withdrawn
|
NAV
|
Units redeemed
|
1
|
Rs.
10,000
|
Rs.
15
|
666.667
|
2
|
Rs.
10,000
|
Rs.
13
|
769.231
|
3
|
Rs.
10,000
|
Rs.
14
|
714.286
|
4
|
Rs.
10,000
|
Rs.
16
|
625.000
|
As can be seen from the above table, at the NAV of Rs. 14, the
investor had to redeem 714.286 units, as compared to 625 units when the NAV was
Rs. 16. Lower NAV meant withdrawal of more units. Now, if the NAV was
constantly growing, such a situation may not pose any trouble. However,
fluctuating NAV would mean that at lower prices, one might end up withdrawing
more units. This would hurt when the NAV starts to recover after a fall.
While SWP is a good facility, one must also understand its
limitations.
From a limitation, let us move onto a benefit of SWP. This might be
the favourite of all – Tax efficiency.
Let us assume that an investor has Rs. 1.50 cr to invest and needs
regular income of Rs. 12 lacs per year.
If one were to get such income through investment in traditional interest
bearing investment option, one would get into the highest income tax slab. Interest
income is added to one’s income and taxed at the marginal rate applicable at
the respective income level.
On the other hand, let us consider SWP for such an investor. In case
of SWP, as we saw in the table earlier, there is a redemption of units. When a
unit is redeemed, the amount received consists of two components – principal
invested as well as earnings thereof.
Let us say, the investment was made when the NAV was Rs. 12. As per
the table above, the first withdrawal happened at NAV of Rs. 15.
Each of the units thus withdrawn was purchased at Rs. 12. The same
was redeemed at Rs. 15. Hence, there would be a profit of Rs. 3 per unit. As
can be seen, the amount of Rs. 15 has two components: Principal value of Rs. 12
and profit of Rs. 3. Thus, in this case, while the investor gets Rs. 15 per
unit, the taxable component is only Rs. 3 – the profit. Principal withdrawal is
non-taxable.
Each transaction might have a different combination of principal and
profit, which one needs to carefully calculate. However, while interest income
of Rs. 12 lacs a year would attract good amount of tax, SWP would result into a
much lower taxation.
SWP will not help you get rid of the tax completely. However, it is
a tax-deferral scheme. Each Rupee of deferred tax allows one to earn till the
time the tax becomes payable. Evaluate your situation and consider the options
very carefully.
(The author is not a tax-practitioner and hence one
would be advised to consult a tax adviser for further details.)
Amit
Trivedi
The author runs Karmayog
Knowledge Academy. The views expressed are his personal opinions.
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