When your clients are looking to generate regular cash flow from mutual funds, they often find it difficult to decide whether or not they should redeem their investments. Currently, mutual fund investors have two options to generate regular cash flow, systematic withdrawal plan (SWP) or dividends. Let us understand what is best suited for your clients.
Dividends in mutual funds
Choosing the dividend option for a mutual fund scheme entitles an investor to receive dividends declared by the fund scheme periodically. Dividends are tax-free for investors. The fund house though has to pay Dividend Distribution Tax (DDT) on such dividends on behalf of investors. This means investors indirectly bear the tax burden on dividend income.
However, in case of close-ended schemes or schemes with a lock-in period like ELSS, the dividend option is preferable. This is because your clients will receive part of the profits throughout the investment tenure. Even though the investment is locked in, they would still benefit from some liquidity from time to time.
Systematic Withdrawal Plan (SWP)
Just as systematic investment plans (SIPs) allow investors to make investments in mutual funds periodically, SWPs redeem your investments periodically. SWPs give investors the flexibility to choose the periodicity and amount of redemption.
Why SWPs score over dividends
Here are three reasons why an SWP is a better option than dividends
- Consistent cash flow: The dividend option does not guarantee regular cash flow since AMCs declare dividends after realising profits, if any. However, with SWPs, your clients can choose to have regular cash flow by redeeming their investments. There is no ambiguity on cash flow with SWPs.
- Control over quantum of cash flow: With SWPs, your clients can decide the amount and timing of cash flow depending on requirement. Simply put, your clients cannot rely on the dividend option to meet regular requirements.
- Tax efficient: The government levies DDT on dividends arising out of mutual fund investments. Since the NAV of the fund is reduced to the extent of dividend, investors end up paying the tax from their MF investments. SWPs, on the other hand, are treated as redemption from mutual funds. The tax treatment of such redemption is just like growth options in mutual funds.
Hence, SWP scores over the dividend option. However, if the periodic payouts are considerably higher than the returns generated by the mutual fund, you should consider recommending the dividend option as the investment amount might get exhausted. There is no such fear with the dividend option, as any dividend has to be declared only out of profits realised.
Karan Datta is the Chief Business Officer at Axis Mutual Fund. The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.