For regular income - equity funds or balanced funds sahi nahi hai ...

Are you seeking regular income from your mutual funds? In that case, please do not look at equity funds or balanced funds. Do not consider regular dividends or even systematic withdrawal from such funds.

Read my article to know more ...

For regular income, equity and balanced funds sahi nahin hai ...

Read the English translation below:

Recent budget proposed by the Finance Minister introduced a tax on dividends from equity-oriented mutual funds. Some mutual fund investors and distributors were upset with this proposal. Some of them had opted for balanced fund seeking monthly dividend. Now these dividends have become taxable. The tax would impact the net amount received in hands.

First of all, let us understand the tax on dividends. This is not the regular income tax that is payable on the income received in hand. However, this is dividend distribution tax, which would be deducted before the dividend is paid out. The dividend that one receives remains tax-free in the hands of the recipient. This means that although the recipient does not have to add the dividend income in the taxable income and calculate the tax on it, it is received AFTER deduction of tax, which would mean that the investor’s returns are reduced.

This is what has upset those who invested in the balanced mutual funds seeking regular income.

We will not discuss about the merit of introducing such a tax. However, the focus of our discussion would be on the choice of equity or balanced funds to seek regular income. Before we launch the discussion, let us also add that now that the dividend is subject to distribution tax, many have started considering regular withdrawal, known as SWP (Systematic Withdrawal Plans) to get regular income. On paper, such a regular withdrawal strategy looks highly tax-efficient in comparison to dividends. This happens since the entire dividend amount is subject to tax, but in the withdrawal case, only the capital gains are taxable and not the capital withdrawn.

The question to consider should be: is it prudent to invest in equity funds or balanced funds for regular income? Very often, people get carried away with the taxes and try to save taxes, forgetting the true nature of the investment category. In the offer document of equity and balanced funds, an important item is called the “investment objective of the scheme”. In all such cases, the investment objective is “to provide long term capital appreciation” and not “to provide regular income”. In fact, even the nature of the asset does not support the ability to pay regular income.

We do not look at liquid funds when the objective is to create wealth. However, liquid funds are ideal when “liquidity” is the prime objective. Exactly in the same manner, if “long term growth” is the objective, equity could be a suitable asset category, but it is not suitable for short periods of time, or for liquidity, or for regular income.

- Amit Trivedi

 

Transcript of my chat on www.moneycontrol.com on 17th December, 2014

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SWP in a mutual fund - a better option for regular income

My article in Mumbai Mid-day Gujarati edition today:

http://epaper.gujaratimidday.com//epaperpdf/gmd/17112014/17112014-md-gm-11.pdf


English translation of the same is as under:

In the last two columns, we have highlighted some points about how mutual funds make it convenient to attain some of our objectives. First we talked about someone who has a regular savings that one needs to invest to achieve long term goals – mutual funds offer a facility called SIP for this. Then we looked at how convenient mutual funds make to buy gold. Let us now look at another category of investors, who need regular income from the investment portfolio.

Such an investor typically looks at certain traditional instruments that offer regular interest income – Post Office Monthly Income Scheme (MIS), Senior Citizens’ Savings Scheme, Fixed deposits, Debentures are some of the options that come to mind. All these are good investment options, but each has certain limitations. Due to these limitations, these instruments may be suitable to only certain investors and only in certain situations.

Let us spend some time in these instruments. All the abovementioned instruments give a feel of safety. However, the level of safety could be very different among all these. The Post Office MIS and Senior Citizens’ Savings Scheme are much safer than debentures issued by companies. Fixed deposits issued by banks are much safer than those issued by Non-Banking Finance Companies (NBFCs). An investor must keep this in mind.

Two features of these instruments must be understood properly. These are: term and interest rate. All the traditional instruments listed above have a fixed term and a fixed interest rate. That gives a good feeling of safety and regularity. However, if we consider the needs of a typical investor and compare the same with the features of these instruments, we start seeing a gap.

·      First of all, the investor may need regular income for a period that is different from the term of these instruments. We may have a five-year debenture available in the market. What if the investor needs regular income for seven years or three years? What about a retired investor, who would need regular income till one is alive and that period is unknown.

·      Secondly, all these instruments have a fixed interest rate. If we consider a retired investor, the income from investments is required to fund regular household expenses. These household expenses do not remain constant – they go up over a period due to the rise in prices of essential items like food or medicines.

Given these two gaps, the traditional instruments, though safe and predictable, may not be suitable to all in all situations.

Hence, there is a need to look at alternatives, if available. One such alternative is offered by the mutual funds. This comes in form of Systematic Withdrawal Plans (SWPs).

How does SWP work?

All mutual funds offer facilities for systematic transactions. An investor is required to give standing instructions to the fund house and they take care of completing the transaction based on the instructions given. SIP is one example of such standing instruction or systematic transaction.

Any investor can invest a lump sum amount in a mutual fund scheme and give standing instruction to the fund house for regular withdrawal of a fixed amount. Let us say, one needs regular income of Rs. 5,000 per month and has a sum of Rs. 5,00,000 that can be invested. After investing the amount in a particular mutual fund scheme, the investor needs to fill up a form for SWP. Every month on the stipulated date, the money would be taken out of the scheme and paid out to the investor.

This small amount withdrawal can be set up irrespective of the gains generated by the scheme. This is possible due to the divisibility of the investment. Though one can withdraw any amount (as long as it is less than the balance in the account), one would recommend keeping the withdrawal rate closer to (preferably lower than) the expected rate of investment growth. If you are expecting the fund to grow at 10@ p.a., keep the withdrawal rate at less than 10% p.a.

At the same time, if one has a need for regular income only for a stipulated period, say 5 years, one can draw the full amount over these 5 years.

SWP is much more tax-efficient than earning interest income from fixed income investments, if the withdrawal is done for a very long period. As compared to traditional instruments, this does not need the full amount to be blocked for the entire period, which means, one can keep withdrawing regularly and keep funding the account whenever other investments mature or when other lump sum amount is available.

A word of caution: please consider this discussion only in the context of liquid and short-term debt funds and no other categories.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.