Long story short, first invest for three years and then go for SWP and the chances of erosion of capital would be significantly less as compared to redemption before three years.
Not long ago, before taxation on equity dividend income was introduced, the dividends issued by various fund houses used to be a regular and reliable source of income for many, especially for retired people. But, with the introduction of taxation on equity dividend income on the basis of concerned tax slab in which the particular individual falls in, things have changed. Now, it might happen that your equity mutual fund dividend income is getting taxed at 30% plus.
Quite shocking & disturbing! Isn’t it? Well, in Don Corleone style, “we do have something to offer that you will not be able to refuse”.
Tax-efficient income
To understand how one can achieve regular yet tax-efficient income from equity mutual funds, let’s delve into the concept of ‘Systematic Withdrawal Plan’. SWP, as the name suggests, involves regular redemption of funds from the invested corpus. The redemption of funds can be on the basis of fixed amount or fixed units, purely dependent on the choice of investors. Two critical questions that would have struck you just now are, how these funds would be taxed and how will your invested corpus look like post redemption of funds. We shall address both the issues:
# Taxation aspect: Since the idea is to redeem these funds post one-year, the redemption will attract LTCG taxation.
# Corpus depletion: This is a major concern that rests on two other critical parameters—fund selection and the time period you let the funds remain invested.
While the fund selection scenario has been covered in length in many articles, we try to estimate the ‘right’ holding period before which you should not start redeeming funds. We did some number crunching on our recommended set of funds and concluded that the optimal time to let the funds remain invested before one can start redeeming is three years. If you start redeeming early, there is a high chance that the corpus will erode quickly. If you wait for more than three years though there won’t be any harm, the wait time will become higher.
To start with, we calculated the rolling return (on daily basis) for the recommended funds category for three time periods; one-year, two-year and three-year periods. While there is not much difference between the returns, the major gap difference comes in between the standard deviation, aka, the volatility of the returns. Now, if we go a step further and apply some higher statistics of the normal distribution, we notice that the probability of negative returns becomes lower as the investment horizon becomes longer.
To keep things simple, 95% confidence interval suggests that 95% of the time, the returns would be capped between the calculated upper and lower limits mentioned. In the current scenario, for a person who would have invested a year back, he will have his portfolio reduced by 20-30%.
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At this juncture, if the investor would have opted for SWP, his/her portfolio would have suffered irreparable damage. On the other hand, if the person would have invested three years ago, the returns on the portfolio will still be more than 10% on an absolute basis and the SWP would make sense in this case.
Long story short, first invest for three years and then go for SWP and the chances of erosion of capital would be significantly less as compared to redemption before three years.
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