Systematic Withdrawal Option: A tax efficient way of earning retirement inflow benefits
Retirement planning stands out as a crucial responsibility for financial advisors. The "accumulation" phase, which involves building a retirement fund, entails channeling savings into various financial instruments. These may include mutual funds, equities, fixed deposits, rental income, pensions, EPF, PPF, insurance policies, post-office savings, tax-free bonds, and dividend income.
The objective here is to secure:
- Inflation-adjusted monthly income upon retirement.
- Tax-efficient or tax-free monthly income in retirement.
It's important to highlight that many individuals tend to overlook the "distribution phase," which is the stage when one relies on the most tax-efficient way to distribute the accumulated corpus for a monthly income.
The primary goal is to ensure that clients receive the maximum income without the burden of taxes significantly impacting the real returns they require during their retirement. One effective recommendation is to consider a Systematic Withdrawal Plan (SWP) to achieve a tax-efficient monthly income stream.
An SWP is established within a corpus, specifying the required monthly withdrawal amount and the duration for which the monthly withdrawals are needed. Since withdrawals occur every month or quarter, it results in the sale of a specific number of units, which can attract capital gains tax.
Withdrawals made within one year may incur short-term capital gains tax based on the tax slab for debt instruments and a 15% (plus surcharge) capital gains tax for equity instruments.
To illustrate, let's consider the scenario of a client who invests Rs 10,00,000 in a debt fund at an NAV of Rs 10 on January 1, 2012. They require a fixed monthly income of Rs 10,000 or Rs 1,20,000 annually, which results in the sale of units each month.
Assuming that the unit price increased by 10% at the end of the first year, and the average selling price for each withdrawal in the year was Rs 10.50, the investor would have sold 11,428 units (Rs 1,20,000/10.50). The capital gains would be Rs 5,715 (0.50 per unit * 11,428 units), and the capital gains tax would amount to Rs 1,714.50 (considering the highest tax bracket of 30% minus surcharge). Despite total withdrawals of Rs 1,20,000, the tax paid for the entire year is only Rs 1,714.50. This rate decreases further after one year when capital gains tax on equity becomes zero and on debt is a flat 10% or 20% after indexation.
In another illustration, if a client invests Rs 10,00,000 in a debt fund at Rs 10 per unit (totaling 1,00,000 units) and needs Rs 10,000 per month or Rs 1,20,000 per year, growing by 5% annually, while the remaining corpus grows at a modest 5% yearly after withdrawals, and there is a 10% tax on capital gains every year (30% in the first year), the corpus can last over 27 years, with a post-tax IRR of 8%.
This approach offers an efficient way to withdraw from a corpus while providing a balance available for estate planning.
(Dilshad Billimoria holds a BBM, LUTCF, CFPCM, and is a Certified Financial Planner and Investment Advisor.)