Ojas is in sales and has been a top performer for most of his illustrious career, which is coming to a close. He has some investments but hasn’t paid much attention to his personal finances. His elder brother Tejas has been managing his investments.
Once he retires, he will need a regular income to meet his expenses. Tejas has told him about several options such as fixed deposits (FDs), bonds, non-convertible debentures (NCDs), the Post Office Monthly Income Scheme, the Senior Citizen Savings Scheme, through which he can earn a regular income in retirement. These all looked like good options to Ojas.
While having lunch with his colleague Arpit, Ojas discussed plans for earning a regular income in retirement. Arpit told him withdrawing money regularly from mutual funds was one way of doing so, adding that it was a tax-efficient and flexible option. Ojas learned that this method was called systematic withdrawal. Arpit suggested he learn more about it from his financial advisor Narasimhan.
Understanding systematic withdrawals
Narasimhan explained the concept to him thus:
Withdrawals from mutual fund investments can be set up to be monthly, quarterly, etc. They can be set up any time, stopped when no longer needed, and the amount withdrawn can be increased or decreased as required. This offers a lot of flexibility.
While you can make systematic withdrawls from any type of mutual fund, it is best to do from a debt-oriented fund the goal is to set up a regular flow of income. More than anything else, the highlight of this vehicle is its tax-efficiency.
A tax-efficient income stream: Mutual Funds are subject to capital gains tax on redemption. This treatment reduces the effective tax to be paid and improves the effective interest earned. FDs and bonds on the other hand are subject to income tax, which is much higher.
Understanding capital gains tax: Narasimhan explained this with an example. Say you invest ₹10 lakh each in a debt mutual fund and an FD. For simplicity, and to compare like with like, we assume a uniform return of 8% a year. Let’s say withdrawals are made quarterly.
In the case of the FD, the 2% interest would be ₹20,000 and the tax (assumed to be 30%; ignoring cess and surcharge for the moment) would be ₹6,000, meaning the retained amount would be ₹14,000. The effective returns would thus be 5.6% a year. Narasimhan explained that this tax would not apply to Ojas if his income was below the taxable threshold.
In case of mutual funds, too, the returns earned would be ₹20,000. To calculate the gains on the withdrawn units, let us assume that the mutual fund unit was bought at a net asset value (NAV) of Rs100. The number of units for a ₹10-lakh investment would be 10,000.
After a quarter, ₹10 lakhs would become ₹10.2 lakh. The units being constant, the NAV would have gone up to ₹102 to reflect the ₹20,000 of earnings in the quarter.
The number of units withdrawn would be 196.08 ( ₹20,000/102). Their original cost was ₹19,608 (196.08 x 100). The capital gain is thus ₹392 ( ₹20,000 – ₹19,608). The tax on this at 30% would be ₹118. the amount retained would be ₹20,000 – ₹118, or ₹19,882. This means the effective return would be 7.95% a year!
Narasimhan also told Ojas that the interest on FDs, once set up, couldn’t be paused, as with systematic withdrawals from mutual funds. This lack of flexibility could translate to unnecessary tax payouts.
Some people set up systematic withdrawals from hybrid or even equity funds. Despite the volatility, this is fine if the withdrawals are small. However, Narasimhan said he usually recommends only debt funds for systematic withdrawals as they as far less volatile than equity funds.
Narasimhan’s insights left a strong impression on Ojas. He was especially struck by the favourable capital gains tax treatment and how significantly it could improve his returns. The strategy seemed like an effective tool to adopt for retirement planning, and he made a mental note to share this valuable tip with his brother.
This is a hypothetical case.
Suresh Sadagopan is managing director & principal officer at Ladder7 Wealth Planners and author of ‘If God Was Your Financial Planner’.