New Dividend rules make a stronger case for SWP


The debate about dividend plans versus systematic withdrawal plans (SWPs) have typically gravitated towards SWPs. SWPs can be more predictable and also more tax efficient. With the Union Budget 2020 announcing the shift in dividend taxation from DDT to withholding tax; the case for SWPs becomes a lot stronger.

What is the shift in dividend taxation?
There are two dividend taxation scenarios that we need to understand with respect to Indian mutual funds. The first is the situation that is applicable till March 31, 2020. In this case there is no dividend tax in the hands of the investor. However, equity funds are subject to dividend distribution tax (DDT) at 10% plus surcharge and cess. In the case of debt funds, dividends are subject to DDT at 25% plus surcharge and cess. 
DetailsDDT RateSurcharge (12%)Cess (4%)Total Tax Impact
Equity Funds10.000%1.200%0.448%11.648%
Debt Funds25.000%3.000%1.120%29.120%

The above rates are applicable till March 31, 2020 and it is the total tax impact that is imposed on the dividend distributed. Let us look at how it changes from April 2020?

Effective April 01, 2020, the DDT will be scrapped altogether. Now dividends earned will be added to total income and charged tax at your marginal rate of taxation. If you are in the 10% tax bracket (including dividend income) then the dividend income will be charged tax at 10.40% including cess. But as you go into higher tax brackets your marginal tax on dividends can rise all the way up to the peak rate of 42.74% effective rate.

SWPs offer a better option for regular withdrawals?
An investor looking for regular payouts from a mutual fund can either opt for a dividend plan or a systematic withdrawal plan (SWP). Dividend declaration is at the discretion of the fund (subject to surplus) but not mandatory. In an SWP, the payout is fixed and depending on the returns, you either withdraw more of returns or more of principal. Here are 3 key advantages of opting for an SWP over a dividend plan.
•Dividends are declared at a fund level and so it is essential for the fund to sell the assets. That incurs costs in terms of transaction costs, statutory charges and opportunity losses. SWPs are specific to an individual and hence don’t need asset sales.
•SWP is more suited to planning cash flows. If you need a cash inflow of Rs20,000 per month, then an SWP is more suitable. Dividends are discretionary and cannot be relied.
•Above all, it is the tax efficiency that really tilts the scales in favour of SWPs over dividend plans. We shall look at this in detail.

How SWPs can be more tax efficient?
We shall look at a live example of an investor who has invested Rs10,00,000 in SBI Banking Fund on 01 March 2018. He withdraws Rs10,000 each month via a structured SWP. The cash flows over the next 11 months will appear as under.
SWP DateNAV(Rs)Amount(Rs)Units transactedBalance UnitsCost of investmentProfit (Rs)Tax (@ 15%)
01-Mar-18       15.135      10,00,000   66,072.02   66,072.02      10,00,000
01-Apr-18       15.118-10,000      -661.47   65,410.55           10,011             -11               -  
01-May-18       16.259-10,000      -615.04   64,795.52             9,309            691            107
01-Jun-18       16.409-10,000      -609.43   64,186.08             9,224            776            120
01-Jul-18       16.203-10,000      -617.17   63,568.91             9,341            659            102
01-Aug-18       17.748-10,000      -563.43   63,005.48             8,528         1,472            227
01-Sep-18       18.171-10,000      -550.34   62,455.14             8,329         1,671            258
01-Oct-18       15.745-10,000      -635.12   61,820.02             9,613            387              60
01-Nov-18       15.741-10,000      -635.28   61,184.73             9,615            385              59
01-Dec-18       16.544-10,000      -604.44   60,580.30             9,148            852            132
01-Jan-19       17.389-10,000      -575.09   60,005.21             8,704         1,296            200
01-Feb-19       16.763-10,000      -596.56   59,408.65             9,029            971            150
Total-1,10,000   59,408.659,1501,415
Data Source: SBI MF

Since his SWP has a principal component and a return component, his tax burden comes to Rs1415 on annual withdrawals of Rs110,000. That is an effective tax rate of just 1.29%. Clearly, SWP approach looks to be quite tax smart!

How would this tax liability look if he had opted for a dividend plan?
Fund particularsTotal Dividend ReceivedTotal Tax on dividends
DDT on Equity Funds (11.648%)Rs110,000Rs12,813
Scenario from April 01st 2020 (Withholding Tax applicable on dividends)
Fund particularsTotal Dividend ReceivedTotal Tax on dividends
Dividend on Equity Funds (31.20%)Rs110,000Rs34,320

The tax incidence will be much higher if you are in the peak 42.74% bracket but we shall not get into that for now. The moral of the story is that SWPs are already tax efficient compared to dividend plans. Post April 2020, it will be all the more so.

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