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Use debt funds for stable income after retirement

Systematic withdrawal plans in these funds offer a tax advantage over bank fixed deposits and annuity plans of insurance firms

Suresh Sadagopan 

Most retired people dip into their savings accounts or turn to bank fixed deposits to meet their regular income needs. At a time when interest rates are coming off, turning to bank FDs can expose you to significant re-investment risk. There is also the taxation angle to worry about, especially if you fall in the highest tax bracket.

Debt mutual funds can be a better option for retirees. By opting for a systematic withdrawal plan, or SWP, in a debt MF, investors can withdraw a pre-fixed amount from a scheme at regular intervals. SWPs are flexible and can be stopped whenever required. The primary benefit of using SWPs is significant tax savings vis-a-vis bank FDs. Not just bank FDs, SWPs in debt funds can be a far superior alternative to pension plans of insurance firms. And it's not just the retirees who stand to benefit. Anyone who wants a regular stream of income - be it those on a sabbatical, those looking to start their own business, or even those simply wanting to augment their cash flows - can benefit from this option.

Let's say one invests Rs 1 lakh in a debt fund and wants Rs 2,000 every quarter. The amount can be arranged for by setting up an SWP. As long as the fund is growing at a rate above the level, it can sustain these regular payments for an indefinite period.

Tax advantage
In SWPs, the units are cashed out based on the amount of money required in each installment. In the above example, the amount cashed out is not interest income. It is just the number of units which would offer Rs 2,000. For tax purposes, short-term capital gains is calculated by taking the difference in net asset value (NAV) from the time of investment to the time it is withdrawn and multiplying it by the number of units cashed out. The gains are added to the income and taxed at slab rates.

Remember that the gains from debt MF schemes are considered long-term after 36 months. Long-term capital gains are taxed at 20 per cent with indexation, while short-term capital gains are taxed at individual slab rates. SWPs would lead to short-term capital gains. But even for a person in the highest tax bracket of 30 per cent (30.9 per cent with surcharge), the gains would be minuscule.

Let us take the example of someone who invests Rs 1 lakh in a debt MF and in a bank FD. For an apple-to-apple comparison, the returns from both the debt fund and the FD are taken to be 8.8 per cent. Assume the withdrawal from the debt fund is at the rate of 2.2 per cent per quarter, which is approximately what one would expect as interest income per quarter from the bank FD. Also assume that the person falls under the highest tax bracket and no exit loads are paid. (If there are exit loads, the SWP can be set up after the exit load period.)

The tax to be paid in the case of the FD on an interest income of Rs 8,800 comes to Rs 2,719. In contrast, the short-term capital gains tax for debt mutual funds on a withdrawal of Rs 8,987 comes to just Rs 146. So, for FDs, the incidence of effective tax turns out to be 30.9 per cent, while for debt MFs the effective tax paid amounts to just 1.6 per cent (see table).

Current interest rate scenario
An FD would offer a fixed return for the tenure of investment. When interest rates go down, FD rates would also decline. While reinvesting the FD, the new rate will apply. This is called the reinvestment risk in financial parlance.

In case of debt funds, the underlying debt instruments go up or down in value based on the rates at which they are traded. The uncertainty in returns is something that unnerves people but it is not as bad as it sounds. And the volatility will not be anything like investing in equities. The rates at which the debt instruments are traded depend on the interest rate cycle, among other things. In a falling interest rate scenario which is unfolding now, debt funds will be positively impacted depending on the kind of debt instruments the underlying scheme holds.

Scoring over annuity plans
An SWP in a debt fund is a far superior alternative to a pension plan. Most people invest in pension plans of insurance companies for a stable income stream. But annuity payments are taxed as income, just like FDs. Annuity payments also have other disadvantages - for instance, the disbursal rate in an annuity plan is typically 5.5-6.5 per cent per annum, which is very low. The returns are even lower when you account for taxation. What's more, annuities once started cannot be stopped, which can be a big handicap when a person wants to access their principal for some exigency. In contrast, SWPs in debt MFs can be started and stopped any time. Also, there are a variety of debt funds to choose from, so the underlying corpus can be invested in funds that have a potential to offer much higher returns as compared to annuity plans. That's not all. The amount required from SWPs can be adjusted over time to suit one's individual needs.


The writer is a certified financial planner

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First Published: Sat, April 11 2015. 21:12 IST
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