It Pays To Be Systematic

Systematic withdrawal plan

For investors looking for a regular income, Systematic Withdrawal Plans are a good way to minimise the tax outgo

It definitely looks like the finance ministry can't make up its mind about whether to tax dividends or not. After making dividends tax free in the 1999-2000 Budget, it was made taxable in the hands of mutual fund investors last year. This change in the dividend structure came as a blow, especially to income fund lovers, as they were compelled to fork out as much 30 per cent of their dividend income as tax.

Earlier, mutual funds used to pay a dividend distribution tax of 10 per cent on their behalf. Equity fund investors now have to pay a 10 per cent tax on dividends received on their investments. Earlier of course, dividends from equity funds were tax free. Investors falling in the high tax-bracket earlier took advantage of the tax arbitrage by investing in mutual funds. But thanks to the change, investors have had to re-work investment strategies.

 

If you are a long-term investor, you always had the option of switching to a growth plan with a minimum investment horizon of one year. By adopting this strategy, you could benefit from the current long-term capital gains tax rates which are lower than personal income-tax rates.

In the case of long-term capital gains tax, you have the option of either paying 20 per cent tax with indexation benefits or a flat rate of 10 per cent. But investors seeking a regular income found the dividend option rather unattractive after the change in structure. But the systematic withdrawal facility offered by mutual funds came to their rescue.

A systematic withdrawal plan allows an investor to invest a lumpsum amount and redeem units for a fixed amount, either on a monthly or quarterly basis. So instead of receiving dividends, the investor can redeem some units for the same amount at the prevailing net asset value (NAV). The tax outgo will be minimal as the investor will have to pay tax only on the difference between the prevailing NAV and the cost of investment.

In case of a monthly dividend plan, the entire dividend becomes taxable leading to higher tax outgo. So systematic withdrawal plans are clearly more tax efficient than paying dividend tax.

Our comparison table clearly illustrates the benefits that the systematic withdrawal plan has over a monthly dividend plan. Here, under the monthly dividend plan, the fund pays out a dividend of Rs 750 every month.

So after deducting tax (we assumed the short term capital gains tax of 30 per cent), the net inflow to the investor is Rs 525.

Under the systematic plan, instead of getting a dividend of Rs 750, you withdraw units for the same amount. The number of units is got by dividing the dividend amount, in this case Rs 750, by the prevailing figures. In our example, the number of units comes to 74.442 units (Rs 750/10.075). The purchase price comes to Rs 744.42 (77.442* 10).

So the tax will only be levied on the difference between the redemption amount (Rs 750) and the purchase price (Rs 744.42) i.e. Rs 5.58. As you can see from the table, the taxable amount varies every month.

While the tax outgo under a systematic withdrawal plan is only Rs 127.14, an investor opting for a monthly dividend plan will have to shell out around Rs 2,300 for the same amount of investment. Therefore, despite rather unfavourable changes in dividend tax rules, you can still maximise your gains by using a systematic withdrawal facility.

Inside Box

Bonus!

Another way to minimise your tax outgo is to opt for the bonus plan option. Mutual funds now offer bonus plans in addition to the usual growth and dividend plans. Here, the mutual fund, instead of declaring a dividend issues bonus units. The change in the dividend tax structure made income funds quite unattractive. So mutual funds introduced bonus plans in their income funds to make them a more viable investment option.

In a bonus issue, the total value of investments remains unchanged. However, there is a change in the NAV depending on the ratio in which the bonus is issued. For instance if the prevailing NAV is Rs 10 and the fund issues a 1: 1 bonus, the NAV falls to Rs 5.

The advantage that bonus plans have is that you only pay long -term capital gains if you hold the units for a year. The cost of bonus units is deemed to be zero for tax calculations and hence they will attract capital gains tax whenever they are withdrawn. But if the same amount was doled out as dividend, the tax outgo would have been as high as 30 per cent if you are in the higest income tax bracket.

A profitable strategy would be to hold on to the bonus units for a year. This way, you would only have to pay long-term capital gains tax.