Systematic Withdrawal Plans – a low-tax option to generate income

A systematic withdrawal plan (SWP) is pretty straightforward. You hold an amount in a fund, fix the amount you want to withdraw periodically from this sum, the equivalent number of units are automatically redeemed each time and you get the pay-out.

We had touched upon SWPs in our article last week, where we had discussed post-retirement portfolios. In this article, we’ll look at how an SWP works well in maintaining a regular income flow and how to go about fixing up an SWP. While SWPs are most used by retirees to manage their cashflows, it can also be used by anyone who wants to set up an income stream from their investments. In this article, we are not discussing about SWP as a tool to withdraw from your equity systematically to avoid timing exits. That is another use for SWP.

What’s an SWP?

For those who aren’t in the know, a quick explanation of what an SWP is first. If you know, skip this section!

The purpose of an SWP is to ensure that you have a regular flow of income to meet expenses by automatically withdrawing an amount from your investment each month (or any other periodicity).

So, if you have say, Rs 10 lakh in a fund, you can set up an SWP to withdraw Rs 10,000 every month. The fund will redeem units equivalent to this Rs 10,000 and pay the amount out to you.

Why do an SWP? Tax efficiency!

Essentially, the benefits of an SWP are as follows:

• One, you wind up paying lower tax on the withdrawn amount than you would if the same amount came to you in the form of fixed deposit interest.
• Two, an SWP is more flexible as it allows you to change the monthly withdrawal to suit your requirements – you can go higher if needed or lower. It is hard to do so in a fixed deposit. It’s also easier to tap into to withdraw a higher amount to meet any sudden large expense.
• Three, it is a far better substitute to dividend pay-out option of mutual funds. You decide how much you want as income every month and not leave it to the AMC to declare what it wishes to. It is far superior in terms of taxation as we will see further below.  Note that dividends are entirely taxed in your hands effective April 1, 2020.

SWPs can be done from any fund but is best done from a low-volatile asset class – like a debt fund – for income generation.  When you withdraw, you pay tax on the capital gain – i.e., the difference between your purchase price and redemption price. If the holding period is less than 3 years, this capital gain is taxed at your slab rate. For longer holding period, gain is taxed at 20% with indexation benefit.

In an SWP, each month a certain number of units are redeemed. For each redemption, there is a cost and a gain. You pay tax only on the gain. The entire withdrawal amount is not taxed. For example, let’s say you hold 1,000 units in fund A, invested at an NAV of Rs 50. Then in the first month, you withdrew Rs 2,000. The NAV then was Rs 52. So you’d redeem 38.46 units. Your cost of these redeemed units is Rs 1923. The gain is just Rs 77, on which you pay tax.

In a fixed deposit, you pay tax on the interest income. So if you receive interest of Rs 2,000 you will have to pay tax on the entire amount. This makes for a huge tax outgo, especially if you are in the higher tax brackets.

The table below takes a fund example and an FD to show the impact of taxes for an SWP run for 1 year and fixed deposit interest. A more detailed break-up is in this excel sheet (refer to sheet Tax Efficiency).

As you can see, the tax paid on SWP is a fraction of that paid on FD interest. In the initial year or two of withdrawal, the gain is lower and the cost component higher as returns are only just starting to come in. In the latter years, the gain component becomes higher. However, once the 3-year period is crossed, indexation benefits kick in. On this front again, the SWP scores as indexation is not available in FD interest.

Bottomline: An SWP is a tax-efficient method to ensure a regular cash flow. It lends itself to greater control and flexibility over the amount of regular income than an FD does.

What should the SWP amount be? Keep it reasonable!

When you want to set up an SWP, the key is the rate of withdrawal. Many of you want your corpus to stay intact or at least not deplete soon.

The withdrawal rate needs to be in line with the approximate return you can get from the debt fund.

If so, the rate of withdrawal should be such that it does not deplete the capital quickly and allows the returns to compound. This ensures that the corpus last longer. Too low a rate will simply leave you short of income.

The withdrawal rate needs to be in line with the approximate return you can get from the debt fund. Typically, short-term and corporate bond funds have delivered average 3-year returns of 7.8% in the past 8-year period. Ultra short and similar funds delivered an average 1-year return of 7.5%. An slightly lower approximation of these can be taken as the withdrawal rate, which works out to 6-7% a year. You can withdraw lesser, but going higher than this rate is not the best idea.

The Excel file linked above (refer sheet Withdrawal Rate) gives an illustration of what your investment value works out to under various rates of withdrawal. It uses a liquid fund as an example, with an assumed investment of Rs 20 lakh in June 2017 and an SWP run from then until June 2020. A quick summary is below. You will see that if you withdraw higher, your corpus is already depleting at the end of year one.

So what if you need a higher monthly sum (and want to keep your corpus intact)? Well, you will either have to scale down your expenses or find other sources of income, or increase the investment amount.

You can use our SWP calculator to check how many years you can run an SWP given your investments and monthly income need.

Bottomline: A reasonable rate of withdrawal is 6-7%. Too high a rate will leave you short of money earlier than you expected and will not allow your investment to grow to support you. Please note that as long as your needs are met, there is no harm in allowing your corpus to deplete over several years, unless you are very keen to leave it behind for your heirs.

Where should you invest? Low volatile only

When you need to make steady withdrawals:

• One, you cannot take the risk that your fund could see big losses or prolonged underperformance. This takes any equity and equity-oriented fund out of the picture. While your corpus can have equity (as we discussed last week), shift it to debt before you need to access the amount for SWP. Also barred are credit risk funds and any other debt fund that holds low-credit papers.
• Two, you cannot afford your fund to have return fluctuations. Volatility in returns means that you may wind up redeeming on losses or that your investment is not going grow steady enough for you to comfortably withdraw from.

The table below gives the lowest 1-month return and the average instances that 1-month returns were negative for different categories.

Low volatile debt categories are usually those that earn returns through accrual. These funds are the most suitable for SWP purposes.

• Liquid funds and ultra short/low duration/ money market funds are the most suited for SWP. The bulk of your SWP portfolio (at least 60-70%) should be in these funds, as the aim is to have steady and safe returns.
•  The liquid category is one that offers the steadiest returns, especially in short-term periods of 1 year and lower and are low risk as well.
• Ultra short and similar categories can generate losses in 1/3 month timeframes and therefore better suited for SWP after say, 6 months to 1 year of holding. But as some funds in this category carry credit risk, check to make sure that you’re not inadvertently taking on risk.
• For other accrual categories such as short duration, banking & PSU debt, or corporate bond, keep investments to a third of the portfolio. These funds can pep up your SWP portfolio returns. But start withdrawing only after completing 2-3 years of holding as these funds need this period for optimum returns. Ensure that you’re not taking credit risk here, either.
• Dynamic bond funds are best avoided. They switch between duration and accrual and this pushes the category’s volatility higher. Not only that, a wrong interest rate call can wipe out returns built up.
• Gilt funds are also volatile given that gilt prices fluctuate based on interest rates. However, if you do want to hold gilt funds because of their low credit risk, you will have to allow at least 5-7 years before you can begin withdrawing from them.

You can use both Prime Funds for funds to invest in. You can also refer to Prime Portfolios for retiree portfolios or our regular income portfolios to see how we have added debt funds for SWP.

What an SWP is not

An SWP does not necessarily mean that your capital will stay intact forever. Based on inflation, your withdrawal and returns you may eventually start drawing down from your capital. Your fund units can go to zero. Maintaining a reasonable withdrawal rate helps push back the time when you draw from the capital and lets your corpus last long enough that you don’t fall short of money. This is unlike an FD, where your principal stays intact.

Make sure you have a diversified income stream with fixed income products such as FD and  Senior Citizens Savings Schemes and use SWP as an add-on.

This article is the conclusion of our series of articles designed to help you manage your portfolio better. You can read the others here:

1. How to invest for the long term
2. Portfolio rebalancing
3. How close to your goal you should move out of equity
4. When you can hold equity even after reaching your goal