Last Updated on May 24, 2022 by Aradhana Gotur
If investors seek regular cash flow from their investments, the automatic choice for many is bank recurring deposits or postal deposits (Monthly Income Scheme). However, declining interest rates on these schemes have made investors question if these investments will be able to beat inflationary pressures to provide sufficient returns enough for their future income needs. Mutual funds have an answer for this, known as SWP. This article deep dives into what an SWP in mutual funds is and its benefits.
Table of Contents
What is SWP?
SWP or Systematic Withdrawal Plan is a technique in mutual fund investments through which investors can withdraw fixed amounts at regular intervals. For example, it can be monthly/ quarterly/ yearly from the investment they have made in any mutual fund scheme. An SWP permits a person to redeem their investment from a mutual fund scheme in a phased manner, unlike lump-sum withdrawals that lead to an exit from the investment at one go. This means, while a part of the investment is withdrawn, the remaining portion of the investment continues to accrue market-linked returns.
It is the opposite of a systematic investment plan (SIP). In a SIP, you channel your bank account savings into the preferred mutual fund scheme for investment. Whereas in the case of SWP, you direct your investments from your mutual fund plan to your savings bank account as a means of redemption of the scheme.
How does SWP work?
An investor is first required to make a lump sum investment into a mutual fund scheme from which the automatic redemptions may be triggered as per requirement. SWP generates cash-flows (income) by redeeming units from the scheme at the specified interval. The number of units redeemed to generate this cash flow depends on the SWP amount and the NAV of the scheme on the withdrawal date.
For example, suppose an investor invests Rs 10 lakh as a lump sum investment in a mutual fund scheme. The purchase NAV is Rs 20; therefore, 50,000 units are allotted to them. Let’s assume the investor started a monthly SWP of Rs 6,000 after one year from the investment date.
In the first month of SWP, let’s say that the scheme NAV was Rs 22. In order to generate Rs 6,000, the mutual fund house redeems 272.728 units (Rs 6,000 / 22 NAV). Therefore, the balance units will now be 49,727.272 (50,000 -272.728).
In the second month, assuming NAV was 22.50, the AMC redeems 266.667 units (Rs 6,000 / 22.50 NAV). Therefore, the unit balance reduces to 49,460.605 (49,727.272 -266.667).
In the third month, making an assumption that the NAV was 23.00, the AMC redeems 260.8696 units (Rs 6,000 / 23.00 NAV) and now the unit balance reduces to 49,199.7354.
This process continues every month till the end of the SWP period set by the investor. As seen in the above example, unit balance reduces overtime in an SWP plan, but if the scheme NAV appreciates at a percentage higher than the withdrawal rate, the investment value appreciates.
To highlight from the above example, after the third SWP payment, the fund value stands at Rs 11,31,593.91 (49,199.7354 units x Rs 23 NAV) against the investment value of Rs 10 lakh, which indicates an appreciation of Rs 131,593.91.
However, if the scheme NAV falls instead of rising, then the effect on your investment value will be the opposite. This is because withdrawals in a scenario where NAV is falling will require a greater number of units to be redeemed.
Benefits of SWP in mutual funds
- Flexibility: In an SWP plan, the investor has the flexibility to choose the amount, frequency and date according to their needs. Also, the investor can stop the SWP at any point in time, add further investments or even withdraw amounts over and above the fixed SWP withdrawals.
- Regular income: SWP in mutual funds facilitates investors by providing a regular income from their investments. Therefore, this becomes highly convenient and useful for those who need a consistent cash flow for meeting recurring expenditures.
- Capital appreciation: In the case of the example mentioned above, if the SWP withdrawal rate is lower than the fund return, the investor gets some capital appreciation too in the long term.
- No TDS: For resident individual investors in India, there is no TDS on the SWP amount which is an added incentive that they get.
Who can use SWP?
Investors looking for a regular source of secondary income
SWP can be a source of creating an additional income stream from long term investments. It can help tide over the rising living cost. Therefore, investing for the long term in mutual funds and withdrawing regularly through SWP may be an easy way to create a regularized source of secondary income.
Those wanting capital protection
Risk-aversed investors may consider investing in moderate or low-risk profile mutual fund schemes and receive only the capital gains as SWP. For example, suppose the initial investment is made in an Arbitrage fund and the capital appreciation is received regularly by way of SWP, there is a possibility that the initial investment may remain at an almost zero risk.
Anyone who wants to create their own pension
Investors who do not have any pension earnings can create their own pension by investing the retirement corpus in schemes suiting their risk profile and earn a regular income at a frequency chosen by them. Therefore, on retirement, the investor may choose to start an SWP and thus, create their own source for pension funds.
Those who are in a high tax bracket
Investors in a high tax bracket find SWP useful as there is no TDS on the capital gains. Also, the long term capital gains from equity / equity-oriented funds are taxed moderately (at a flat 10% on returns above Rs 1 lakh in a financial year). Gain from debt-oriented funds is also moderate as indexation is allowed on the long term capital gains.
Tax efficiency through SWP
When units are redeemed to draw the SWP amount, it attracts capital gain (in case the redemption NAV is higher than the purchase NAV) on the profits made from the sale of units. The capital gain can be defined as short term or long term as per the following conditions:
- Equity / equity-oriented funds: If redeemed within 12 mth from the date of investment, these are treated as short-term gains and taxed at 15%. Gains made after 12 mth from the date of investment are treated as long term and are tax-free up to Rs 1 lakh in a financial year. Long term capital gains over Rs 1 lakh are taxed at 10%.
- Non-equity funds: If redeemed within 36 mth (treated as short term capital gain) from the date of investment, the gains are added to the investor’s income and taxed at the slab rate applicable to them. Gains made after three years are treated as long term and taxed at 20% after allowing indexation benefits.
In summary, if an investor can analyse what is a Systematic Withdrawal Plan in a mutual fund, they will find that SWP is a good strategy to have a regular income. An SWP can also be set up to withdraw only the capital appreciation portion. The good part is that the returns are tax-efficient and there is no TDS on gains, unlike traditional investment options.
