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

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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  • One, you wind up paying lower tax on the withdrawn amount than you would if the same amount came to you in the form of fixed deposit interest.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.

prime funds

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.

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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
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10 thoughts on “Systematic Withdrawal Plans – a low-tax option to generate income”

  1. orczeikwiyvnbhhkcv

    Hello ma’am
    My mother wants to invest around 10 lakhs, so should I go with SWP route with IDFC short bond or Kotak Franklin debt fund as she needs quarterly income of sorts, or go with fixed deposit with HDFC/Bajaj (she doesn’t have any income so tax is not something to worry about)

  2. Kishan Magatapalli

    Hello Madam,
    In the Excel file that is attached, we can see that the corpus has decreased by 31000 in the SWP method. So at the end of the year the total would be
    1969143 + 135000 – 1097 = 2103046
    And in the FD method at the end of one year
    2000000 + 135000 – 40500 = 2094500

    So the difference at the end of one year between the two methods is Rs 8546. I feel that is what the metric of advantage of SWP method and not what is getting depicted on the tax front. This is probably since the rate of withdrawal is higher than the CAGR of the fund. Am I doing a wrong calculation? Please correct me if I am wrong.

    Secondly I feel that regular income from any source will generally be required by Senior citizens. In the average middle class, senior citizens will very rarely be in the 30% bracket. Maximum would be in the 0% or 10% bracket generally. If they are in 0% bracket, wont the FD method be very advantageous as compared to the SWP method, since in the SWP method the investor is left with 2104143 in the year end, while in the FD route the total corpus would be 2135000?

    Please correct me if I am wrong in the calculation somewhere

    Regards
    Kishan

    1. Bhavana Acharya

      Hello sir,

      Let me clarify a little bit:

      1. No, the value of the fund at the end of year 1, after withdrawal is 19,69,413. This is after withdrawing Rs 135,000 in total.
      2. The capital in the FD will be intact, yet. This is mentioned in the last point in the article. The reason the fund’s value has dropped from the initial investment is because the withdrawal rate is slightly higher than the return of the fund in that year. But over the next years, the return will compound and the investment value will improve. You can see this in the withdrawal rate sheet – see the 6% withdrawal rate columns, where the value depletes first and then comes back up. This is one of the reasons we need to keep a reasonable withdrawal rate to allow returns to accrue.
      3. The tax will be lower than FD even at lower tax brackets, simply because the amount of money on which you are paying tax is significantly lower than in the FD. If you’re not paying tax because your income level is not that high, then you wouldn’t be on the SWP either. The SWP still gives you flexibility in withdrawals.
      4. You can well live on interest income alone if you wish to, as we talked about in last week’s article. Adding debt funds with SWP is useful for tax-efficiency, diversification, and better returns for. As mentioned in the last section of the article, it is essential that you have a combination of different instruments.

      Hope this helps.

      Thanks,
      Bhavana

  3. But if you hold an arbitrage fund for one year and then start an SWP, the gains will be taxed at only 10% (equity taxation). It is not risky if held for more than one year.

    1. Bhavana Acharya

      Hello sir,

      On the returns front, ultra short/low duration are much better than arbitrage. Next, once you cross 3 years, the indexation benefits can reduce the taxation quite significantly. So if at all arbitrage has a benefit, it is for a very brief period. It just safer and easier to use pure debt funds instead of an equity-based product, even if low risk.

      Thanks,
      Bhavana

  4. Kannan Narayanan

    Dear Madam, Excellent article with clear examples. I am very much satisfied as a PrimeInvestor subscriber. Thank you to the whole team.

    1. Bhavana Acharya

      Hello sir,

      No, it is best to go with liquid funds. Arbitrage is higher volatile than liquid, and have instances where 1 month returns are negative. And where arbitrage opportunities are not available or in markets like the one we are in now, it can get difficult for these funds. In terms of returns, ultrashort/low duration etc beat them.

      Thanks,
      Bhavana

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