Monday, December 1, 2014

SWP - part two

This article, second of the two articles on the subject, explains two important features of SWP:

  1. Tax benefit, and
  2. Impact of NAV fluctuations on the withdrawals
Happy reading ...


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:
Amount withdrawn
Units redeemed
Rs. 10,000
Rs. 15
Rs. 10,000
Rs. 13
Rs. 10,000
Rs. 14
Rs. 10,000
Rs. 16

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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