Systematic Withdrawal Plan (a.k.a. SWP) is a well-known strategy in Mutual Funds to withdraw portions of your investment in tranches while continuing to stay invested for the long term. Just like SIP, it works well for the obvious reason of not trying to time the market. There is however a lesser explained nuance on the tax implications that could vary depending on how you execute your redemption on your Mutual Fund portfolio.
The basic goal behind doing SWP is to generate regular cash flow. After all, you are investing to get back your money at a certain point in time in the future. Say, you have invested INR 100,000 of 1000 redeemable units of a mutual fund (each unit costing INR 100 at the time of purchase), and want to withdraw X% capital appreciation every year. Assume for the sake of explanation, on average the appreciation is 10% p.a. This implies, the investment amount now appreciates to INR 110,000 at the end of year one. You then decide to withdraw INR 10,000, and let the remaining INR 100,000 continue to be invested.
So what is happening behind the scenes here?
Your total fund units are getting depleted. In this case, each redeemable unit at the end of the first year is worth INR 110000/1000 units = INR 110. Hence, your first redemption is liquidating INR 10000/ INR 110 = 90.9 units. You are now left with 1000 – 90.9 = 991.1 units. What are the capital gains out of your redemption? It is not INR 10,000 as few might think! 90.9 units were bought at INR 100 apiece originally, total value amounting to INR 9090, and sold at INR 10000 (the redemption amount). So the capital gains is 10000 – 9090 = INR 910.
Why is this relevant at all?
Because, as you start doing SWP, each year the number of redeemable units starts getting reduced, and the gain on each unit keeps getting appreciated (since the purchase cost of each unit is always the same i.e. INR 100). Hence, for the same yearly SWP amount of INR 10,000, the capital gains keep increasing. These become relevant when considering when and how much capital gains tax would be liable to pay.
If you wish to defer your capital gains tax to the future (but keep on paying more incrementally in proportion to your gains), then you can follow the above simple SWP strategy.
But there are two things to consider.
- Making the best use of the INR 100,000 LTCG (Long Term Capital Gains) exemption limit. If you defer your bigger capital gains chunks to the future, these might go over this limit, and increase your tax liability which you could have otherwise negated in early years.
- The current LTCG is 12.5% in 2024 at the time of writing this blog. There is no guarantee that this will not increase in the future (considering how the tax burden has been increasing with each passing year!). If the LTCG gets to 15-20% in the future, it will be effectively a loss-making proposition for you.
One of the strategies I build is to have a uniform capital gains distribution over the years. This might sound a bit lame initially, but think about how you would benefit if you redeem your entire Mutual fund invested units, pocket the gains, and buy back your originally invested amount again. In the above scenario, I would sell all 1000 units tuning to INR 110,000 to get INR 10000 gains (cash flow that I require), and then buy back INR 100,000 again. Each year I continue to pay LTCG INR 10000, and if I plan it well, I might even keep the burden within tax exemption limits. Also, I’m not worried about deferring bigger chunks of gain to a potentially larger LTCG in the future.
Let this sink in. It is just simple mathematics, but sometimes just a small change in redemption strategy can help guard against bigger tax burdens.
