Large number of senior citizens in India depend on returns from fixed income, mainly interest from fixed deposits, for their living. Also, since the vast majority in India work in the unorganized sector without any pension benefits, a regular source of income is important in old age. Only a small minority has done financial planning for retirement. Therefore, returns from fixed income products are hugely important. We are living at a time of low interest rates, globally. In India too the central bank has been cutting interest rates to stimulate the economy. This has resulted in declining interest rates on banks’ fixed deposits, impacting depositors adversely. Is there a way out?
Investing in Systematic Withdrawal Plans (SWPs) in equity/ hybrid mutual funds is a smart way of earning tax-efficient superior returns. To assess the efficiency of a fixed income product we have to look at the real return. Real return is nominal return minus inflation rate. If the interest rate is 7 percent and inflation is 6 percent, the real return is only 1 percent. Post-tax, the real return can be negative. Therefore, in purchasing power terms, the investor is losing money. Also, it is important to understand that the depositor has to keep 6 percent of the original deposit (the inflation rate) to preserve the value of her original investment. This leaves no return for the investor in real terms. Compared to bank FDs, SWPs are clearly superior products.
Under SWPs the investor withdraws regular amounts from his investment in equity/hybrid funds after one year. Since the withdrawal is done after one year, the returns are treated as Long Term Capital Gains. LTCGs are tax-exempt up to Rs 1 lakh a year and beyond 1 lakh are taxed at only 10 percent. Also, for tax purposes, the withdrawals are treated as withdrawal of original investment and capital gains in equal proportion. Therefore, the tax incidence will be much lower. Let us take an example. Suppose an investor invests Rs 10lakhs in an equity/ hybrid fund. Assuming a return of 10 percent (the long period average is more than 14 percent), the original investment will grow to Rs 11 lakh after one year. 1 lakh as a percentage of 11 lakh is only 9.09 percent. So 91.91 percent is the principal component and 9.09 is the capital gain component. For tax purposes the withdrawals are treated as in the same proportion in original investment and capital gains. So only Rs 9090 (9.09 % of Rs 100000) is liable to be taxed. This is much superior tax treatment and smarter investment.
However, there is a catch. The return that we assume is the long-term return. The volatility in return in the short-term can make calculations problematic. But, in the long run, this principle will hold good. Hybrid funds, which are less volatile, will be more appropriate for SWPs. So, for regular returns, go for SWPs.