An analysis of Dividend vis-a-vis SWP

Of late we see that there is a lot of interest in Mutual Fund Dividends and Systematic Withdrawal Plan (SWP) as income solutions for investors. Many investors prefer dividend options for regular income, but there is a growing interest in SWP in the last few years. Let us now compare and contrast the two solutions. Let us also discuss various factors, which can help investors make informed decisions.

*What is dividend option?*

In Dividend Option the profits made by a scheme are distributed to investors at regular intervals as dividends. SEBI stipulates that dividends can be paid from accumulated profits. Investors should note that, as per SEBI regulations, only realized profits (when portfolio securities are sold at profit) are eligible to be distributed as dividends. Fund Managers may not pay the entire profit realized by the scheme during an particular period as dividends. They may retain certain amount of profits in the accumulated profits reserve, so that they can continue to make dividend payments during rainy days (periods in which the scheme does not make profits). It is important for investors to note the following with regard to Dividend options:-

*1. Mutual fund dividends are not assured* They are paid at the discretion of the fund manager/AMC. Schemes which were paying regular dividends can stop paying dividends for an indefinite period of time.

*2. Mutual Fund schemes can reduce or increase dividend* payout rate at their discretion – depending on market conditions and outlook.

*3. There is no fixed day* of a month for monthly dividend payments. The AMC decides the day on which dividend will be paid in a particular month or quarter.

*4. The dividend paid per unit will be stripped* from the NAV of the scheme and ex-dividend NAV of the scheme will be net of dividend pay-out.

*5. Mutual Fund dividends are tax free in the hands of the investors* but the AMC has to pay dividend distribution tax (DDT) before paying dividends. The DDT rate is 28.84% for debt mutual funds. In 2018 Budget, the Government introduced 10% DDT for equity or equity oriented mutual funds (prior to FY 2019, dividends paid by equity funds were tax free).

*Dividend impact on NAV*

Dividend plans with differing frequencies of dividend distribution have different NAVs, I.e. if a scheme has 4 dividend options, each option will have a different NAV.

*Difference with Stock Dividends*

When stocks declare dividends, the market takes it as a strong sign that the company is doing well and the business is generating enough profits to not only continue/expand operations but also give some amount back to investors.

As a result, when companies declare dividends, usually the stock price doesn’t decrease by as much as the dividend amount due to this positive signal.

However, with mutual fund dividends, this entire signaling effect is not applicable.

In fact, since not giving dividends often leaves investors annoyed, many funds give back capital even when they should be staying invested.

When stocks announce dividends, the original investment stays & the effects of compounding stay intact – any dividend earned doesn’t reduce the original investment. However, with mutual fund dividends, this compounding effect is diminished as the investor periodically reduces his invested amount.

If your objective is to receive a periodic income from your investments, then rather than opting for the dividend plan, you should choose the growth plan and setup systematic withdrawals of similar amounts.

Unlike paying DDT on the entire amount received as dividends, in this case the investor will only pay the appropriate capital gains tax on just the amount of gains, and not the total amount withdrawn.

Mutual fund dividends plans aren’t usually focused on earning dividend income, unless it’s defined in the stated objective.

Instead, they are more akin to systematic withdrawal plans that enable investors to take out some money at pre-defined intervals If the objective is to make periodic withdrawals, the same can be achieved in a more tax-efficient manner than the Dividend plan, as discussed above.

On the other hand, if the objective is to receive a periodic income from your investments above capital appreciation, then investors should invest in stocks directly.

*SWP or SYSTEMATIC WITHDRAWAL PLAN*

SWP is an investment option offered by mutual funds, whereby investors can draw a fixed amount every month (or any other interval as specified by the AMC) from a mutual fund scheme on a fixed day of any month (or any other interval).

The AMC makes SWP payments to investors by redeeming the required number of units at prevailing NAVs; the balance units remain invested and grow in value with growth in scheme NAV. You can think of SWP as a series of redemptions from your lump sum investment to meet your cash-flow needs. SWP facility registration offers investors the convenience of the AMC taking care of the redemptions on an ongoing basis.

The biggest advantage of SWP versus dividend option is assurance of fixed cash-flows as long as there is sufficient unit balance. Investors opting for SWP should note the following:-

1. Cash-flows will be generated for you by redeeming units of scheme where you have invested. Your unit balance will go down over time.

2. If you want more cash-flows, higher number of units will have to be redeemed and your unit balance will be lower and vice versa. You should choose your withdrawal rate carefully.

3. You will continue to receive fixed SWP payments irrespective of market conditions, but you should remember that in bear markets more units will have to be redeemed to meet your SWP payments.

4. SWP payments made within the exit load period of a scheme will attract requisite charges. Therefore, it is recommended that you begin your SWP after the exit load period.

*Is SWP always better than dividends?*

SWP can be better or worse than dividend option, depending on the decisions made by the investor. If the SWP withdrawal rate is reasonably low, then in the long term SWP can give superior post tax returns. However, if the SWP withdrawal rate is too high then the units will diminish at a faster rate and the investor runs the risk of running out of funds. Ideally, the SWP withdrawal rate should be lower than the average long term ROI of the scheme. While SWP gives investors the convenience of fixed regular cashflows, investors should also be flexible about reducing their withdrawal rates in severe market conditions (e.g. severe bear market lasting for several quarters).

*1. Systematic Withdrawal Plan is used to redeem your investment from a mutual fund scheme in a phased manner. Unlike lump sum withdrawals, SWP enables you to withdraw money in installments. It can be viewed as an opposite of SIP. In SIP, you channelize your bank account savings into the preferred mutual fund scheme. Whereas in SWP, you channelize your investments from the scheme to the savings bank account. It is one of the strategies to deal with market fluctuations.

With the Systematic Withdrawal Plan, you can customize the cash flow as per your requirement. You can choose to either withdraw just the capital gains on your investment or a fixed amount. This way you will not only have your money still invested in the scheme, but you will also be able to access regular income and returns. The money that you withdraw can be used to reinvest in some other fund or can be retained by you in the form of cash.

*2. Why do I need a Systematic Withdrawal Plan?*

You may know that your mutual investments always face the market fluctuations. It means that these fluctuations may impact the fund NAV adversely. Especially, when an individual is approaching a goal, the fund returns may erode if not withdrawn on time. So, with the help of an SWP, you can time your withdrawals as per the financial needs. If your goal requires to be funded in a phased manner, then you may opt for an SWP. It will ensure availability of the funds at the right time. In this way, goal accomplishment may not get delayed owing to a cash crunch.

SWP also helps investors who want a second income in addition to their salary from the job. With this plan, you as an investor can create a flow of income from your investment that is regular. If you seek to have periodic incomes for your travel or other needs, this is a great way to set this provision. It should be created in such a way that when you need cash the most, it is available.

*3. Why is the Systematic Withdrawal Plan a good investment option?*

There are two main reasons why this is a wise investment strategy. Firstly, these withdrawals which are also referred to as redemptions, are not subject to tax deductions at source. The capital gains though are taxed on the withdrawn amount. You may also opt for setting up your withdrawal in such a manner that you only draw the appreciation that is made on the investment amount. This keeps your capital invested while at the same time you enjoy the gains on a regular interval.

*4. The withdrawal options*

With the fixed withdrawal option, you can access a specified amount from your investment on either a monthly or a quarterly basis. With the appreciation withdrawal option, you may withdraw only the appreciated amount on a monthly or a quarterly duration.

*5. How does a Systematic Withdrawal Plan work?*

When you choose a Systematic Withdrawal Plan, it affects your mutual fund account as well. It is important to note that an SWP is not the same as opening a fixed deposit account in a bank where you receive monthly interests. With a fixed deposit, the corpus value is not impacted when you withdraw the interest but in the case of a systematic withdrawal plan in mutual fund schemes, the value of your fund is reduced by the number of units you withdraw.

With each withdrawal, your mutual fund will see a decline in its units. At higher NAVs, you may redeem fewer units to fulfill the cash requirements. Conversely, as the NAV falls, it would have the opposite effect, requiring the redemption of more units. An important aspect of benefiting from this plan and making the most of it is by planning the SWP keeping in mind your needs and your end goal. It can have a detrimental effect on the value of your fund if you go for unplanned withdrawals.

*6. Tax Implications of Systematic Withdrawal Plans*

The redemption via systematic withdrawal plan is subject to taxation.

In case of debt funds, if your holding period is less than 36 months, then the amount that you withdraw will form a part of your income. It will then be taxed according to your income slab. On the other hand, if the holding period is more than 36 months, then the long-term capital gains will be taxed at 20% with indexation.

In case of equity funds, if your holding period is less than 1 year, then the withdrawn amount will be taxed at the rate of 15%. On the other hand, if the holding period is more than 1 year, then the long-term capital gains will be taxed at 10% without indexation.

*7. SWP payments are subject to capital gains tax.*

In debt funds capital gains made in units redeemed for SWP within the first 3 years from the date of investment will be taxed as per the income tax rate of the investor. Capital Gains (debt funds) made in units redeemed after 3 years from date of investment will be taxed at 20% after allowing for indexation. In equity funds capital gains in units redeemed within 12 months from date of investment will be taxed at 15%. Capital gains in units redeemed after 12 months is tax free, as long as the total capital gains in a financial year do not exceed 1 lakh.

*Tax Efficiency - Dividend or Growth*

The dividend option has been advocated as the way to earn regular cash flows from the mutual fund investment. The impression that the dividend is an extra return has made investors choose this option to the detriment of their long-term goals which will suffer because the dividends actually bleed the longterm corpus that is being built and reduces the compounding benefit to the portfolio.

Investors choose the dividend option on the basis of two misconceptions—one, investing in debt funds with monthly dividend option is equivalent to getting monthly income from the mutual funds, and second, that this dividend is profits that they are reaping out of their mutual fund investment over and above the NAV. I constantly dissuade them of these notions and try and educate them that the dividend is coming out of their investment.

There have been instances of misselling too, where the dividend is projected as a guaranteed feature. The latest instance involved the balanced fund category in 2017, where Fixed Income investors were lured into these schemes on the basis of the continuous dividend paying record of the schemes in the good equity market scenario of 2015-2017. However, this ended when markets crashed in 2018, and the category since then has been seeing huge outflows every month.

A better way to generate regular cash flows from mutual fund investments is to redeem units periodically to the extent required. Unlike the dividend option where there is no certainty on the amount of dividend and the dividend decision is made by the fund management, mutual funds provide the facility of systematic withdrawal plans (SWP) where investors can specify the amount of money required and the periodicity and the mutual fund will execute it by redeeming the required number of units. Using the SWP option gives certainty of income that is not there in the dividend option.

You must not confuse return with cash flow. If you need cash flow then you must select the SWP, which is not only tax-efficient but also does not create the illusion that this is additional income, The drawback, if it can be considered that, is the capital invested may also be withdrawn over time. As long as your annual withdrawal rate is well below the expected return and you judiciously calibrate the process where needed, your capital remains intact over time.

The dividend and growth option were played-off against each other since the tax treatment of returns as dividend and as capital gains were taxed differently.

But with a 10% dividend distribution tax now being imposed on dividends that are distributed and a longterm capital gain tax of 10% on gains over ₹1 lakh per annum in case of equity funds, and a dividend distribution tax of 25% and LTCG of 20% with indexation benefits on debt funds, the choice becomes a little more nuanced.

How do they stack up? In case of equity funds, the DDT of 10% is applicable on the entire amount of dividend. If a systematic withdrawal plan was used to withdraw a specified amount, then the tax will apply only on the capital gains over ₹1 lakh per annum and not on the total amount withdrawn.

The SWP option to generate post-tax returns is clearly superior to the dividend option. In case of debt funds, the availability of indexation benefits on long-term capital gains makes the SWP option even more attractive from a tax perspective. In the SWP option the units held will go down as redemption happens. In the dividend option, the NAV will deduce as dividends are paid out.

The dividend re-investment option, a sub-sect of the dividend option, hits the investor twice-over with tax. First, the DDT is deducted when the dividend is paid, even if it is re-invested in the same scheme. Second, when the investor withdraws the investment, there is a capital gains tax, too, that they are liable to pay. This double tax whammy makes this option completely useless for the investor seeking growth in investments.

Investors in mutual funds are looking for either long term capital appreciation or income from their investments. The dividend pay-out and re-investment options do not give investors any advantage in either of these goals on a post-tax basis. The combination of growth option along with a systematic withdrawal plan is what works for investors in the current tax scenario. Investors should consider switching their investments into the growth option to limit the damage.

Remember, there are exit loads and taxes applicable on such switches, which need to be taken into account.

*CONCLUSION*

We have compared Dividend option. SWP gives the comfort of predictable cash-flows and superior post tax returns. Unlike dividends, SWP gives power to the investor to decide cash-flows. However, this power can be a double edged sword and therefore, must be exercised with utmost caution and great restraint - investor's withdrawal rate should be reasonable low, so that he can create wealth in the long run. My view is SWP rate should not be more than 7-8%.

To know more about Dividend vis-a-vis SWP, kindly contact Jayant Harde on 9373284136 or +91 7122282029. You can also visit our website: www.jayantharde.com