Investors time withdrawals optimally to save on tax

The systematic withdrawal plan, or SWP, could be called the lesser known cousin of the much talked about and publicised systematic investment plan (SIP).

There's yet another cousin — the Systematic Transfer Plan (STP). In SIP, you invest a fixed sum of money at regular intervals (monthly/ quarterly) to buy some units of a mutual fund scheme. In SWP, as the name suggests, you do the opposite: You redeem some mutual fund units from your portfolio to get a fixed sum of money at regular intervals (monthly/quarterly/half year/yearly).

In SIP, you get a higher numbers of units when the markets are down, and lesser in a buoyant market. In SWP, going by the product logic, you redeem higher number of units when the markets are down and lesser number of units when the markets are rallying.
This is because the amount you want to withdraw is always kept fixed. So SWPs are not very suitable for equity schemes but work better with debt schemes. A variation of the SWP that allows withdrawal of a fixed amount at regular intervals can take the form of withdrawals where only the appreciation in your portfolio, which is not always fixed, is withdrawn at regular intervals.

Using SWPs effectively

While retired people use SWP the most, it could also be used by corporates to pay advance tax and employee salaries, by parents to pay for their child's school fees, by professionals, corporates and others to pay service tax, and several other cases where there is a need for payment at regular intervals.

The structuring for each, to make them most tax efficient, could be done looking at the cash flow of the investors and also the regularity and amount of payments. One of the most effective ways of settling for an SWP when most of the portfolio is in equity-oriented schemes, is to first shift part of the total corpus into a liquid fund, and the rest, which would be required after a year or more, into debt funds. In this way the tax incidence would be much less.

Another way of restructuring a portfolio for an SWP is to shift part of it into a liquid scheme, another part in one or more debt fund(s), and shift from the equity portfolio to the debt portfolio whenever there is a rally in the equity market.

Watch out for tax incidence

According to Mittal, one of the most important things to look at in SWPs is the incidence of tax on withdrawals. In this case, financial planners should take care of the indexation benefits under the Income Tax Act.

For example, if one invests in a debt fund before March 31, 2013, and withdraws in April 2014, he/she would be eligible for double indexation benefits — for fiscal 2013 and fiscal 2014. That is, by investing for a little over a year, one can reap tax benefits for two years.
On the other hand, if one invests in a debt fund in say April 2013, and withdraws in October 2014, that is for about one-and-a-half years, he/she will be eligible for benefits for just one year. So here, even if the investor earns for 18 months, he/she gets the indexation benefits only for one year. Thus, because of some mismatch in timing the investments and withdrawals, a part of his/her gains are paid as taxes.

The timing of investments and withdrawals are very important for making the whole portfolio tax efficient. Keep in mind the earnings expectations from debt investments, the inflation index and the duration for which you are investing.

Usually during the accumulation phase in one's life, the portfolio is heavily tilted in favour of equity-oriented schemes, while during the withdrawal phase it should be tilted towards debt funds, with a tax-efficient SWP in place.