Investors who desire a regular flow of income from mutual funds usually choose between dividend investing and Systematic Withdrawal Plans (SWPs). Though both methods provide periodiccash flows, the way the government taxes them impacts the net return. Therefore, an understanding of the best tax-efficient option can help investors in planning better.
What is a systematic withdrawal plan?
A systematic withdrawal plan allows an investor to withdraw a fixed sum of money from their mutual fundinvestment at fixed intervals. Instead of receiving dividends on the fund, investors withdraw a portion of their holdings, principals, and profits together.
Tax treatment of SWP
Here’s how taxes are levied on SWP:
Equity funds: Tax is levied only on the capital gains portion of every withdrawal. Anything more than Rs. 1.25 lakh of Long-Term Capital Gains (LTCG) is taxed at 12.5%. On the other hand, short-term gains are taxed at 20%.
Debt funds: These are taxed according to the income tax slab of the investor, irrespective of the holding period. Investors can, however, plan their withdrawals strategically. For example, redeeming before March 31, 2025, means the gains will be added to the investor’s income for that financial year, potentially increasing their tax burden if they fall into a higher tax bracket. Conversely, redeeming after April 1, 2025, shifts the tax liability to the next financial year, which could be beneficial if the investor expects lower taxable income, thereby falling into a lower tax slab.
What is dividend investing?
Dividend investing involves choosing mutual funds that distribute their returns to investors in the form of dividends. These funds offer a regular income, but they are subject to taxation.
Tax treatment of dividends
Mutual fund dividends are taxed based on the investor’s tax bracket. Investors in the highest tax bracket (30%) pay a much higher tax on dividends than investors in other tax brackets.
Example: If an investor receives Rs1 lakh as a dividend and is in the 30% tax bracket, they will have to pay Rs 30,000 in tax, which will reduce their net returns.
Drawback: The whole dividend income is taxed at the individual’s income tax rate, which will impose a greater tax burden than SWP.
Other factors to consider
Investors need to consider a few more factors prior to investing:
Impact on the fund’s NAV
- Dividends reduce a mutual fund’s Net Asset Value (NAV) because they are distributed out of the fund’s corpus.
- SWP withdrawals redeem units but do not affect NAV at a structural level.
Investment goals and liquidity
- SWP suits investors with specific income and tax optimisation requirements.
- Dividend investing could be more suitable for investors seeking automatic payments of income.
Conclusion
Given the current tax structure, SWPs often provide greater tax efficiency compared to dividend payouts, particularly for investors in higher tax brackets. By carefully planning withdrawals, investors can manage their tax liabilities more effectively with SWPs. It’s advisable to consult with a tax professional to tailor investment strategies to individual financial situations and goals.
