Systematic Withdrawal Plan Still wins over Dividend Distribution !
The recent budget amendment made a minor change to wordings and increased the tax on dividend distributed 22.08% to 28.33%. And this distribution is not taxable in the hand of investors.
Earlier the tax was same 28.33% on the amount paid to the investor as dividend. For example, if investor received Rs.77.92 as dividend, 28.33% of this amount will be Rs.22.08. The payout from the fund was Rs.100 (77.92+22.08). The NAV is reduced accordingly after the payout. For Rs.100 payout from the fund, the tax worked out to be 22.08%.
This is changed now.
Mr.Finance Minister wants this 28.33% to be calculated on the Rs.100 payout. In the new calculation, government will receive tax of Rs.28.33 and Investor will receive Rs.71.67. Almost 10% increase in taxes.
In addition to this change, as we saw earlier, short term capital gain duration was increased from 1 years to 3 years. So, some one at 30% tax bracket will continue to pay STCG at 30.9% rate for 3 years. But if the same investor chose the dividend distribution method, he only have to pay 28.33%, a clear savings of 2.5%. Some financial planners and journalists addressed this taxation aspect at the surface and concluded saving this 2.5% is a better deal and recommended this strategy in their blogs and columns.
If an investor is investing money for shorter duration (within 3 years) and plan to withdraw 100% of the capital, this difference is good for Dividend Distribution Method. Here in this article, I tried to address a situation where the withdrawal is systematic and will run for several years.
It is not easy to conclude quickly without us doing a detailed analysis, and check everything under the hood. Also if you only compare for one year, we tend to ignore the indexation benefit that kicks in later. Hence we increased the period to 5 years. If we are planning for regular withdrawal on a retirement corpus, we think the period will be 10-20 years or more.
These are our assumptions.
Let us see how the dividend distribution method works under new taxation rules. This is flat tax system. Our assumption is fund manager is passing 100% of the accrual (0.75%), Rs.7500 to the investor after paying taxes. Tax is Rs.2,125 and remaining balance Rs.5375 goes to the investor. Investor receives 71.67% post tax.
Next let us assume, short term capital gain taxation only, regardless of the 5 years period.
Do you notice the effective tax rate has gone down from 28.33% to 6.1% ?
We were told that 30.9% is the tax rate on STCG and it is worse than than the 28.33% !! But we are not paying anywhere closer to 30.9%, not even double digit ??
Even though the STCG is taxed at 30.9%, all withdrawal amount is not treated as income. Systematic withdrawal plan brings a portion of the original capital invested along with gains. Actually, a good majority of it is the original investment amount. In fact, in the first month withdrawal of Rs.7,500 has only Rs.56 as gains on which the 30.9% tax is applicable. Rs.7,444 is received as tax free income. Original capital returned to investor is never taxed. Several financial planners miss this aspect, comparing the DDT with top marginal tax bracket of 30.9%.
Table-2 still has only short term capital gains considered.
With new tax rules, withdrawals after 3 years will be subjected to 20% taxes with indexation benefit.
Last 10 years the Indian inflation index has averaged to 7.9%. Cost indexation benefit is available for long term capital gains. For third year it is 126% =(1+7.9%)*(1+7.9%)*(1+7.9%)
Using that, let us complete this analysis. Check how the tax is dropped from month 37 in table-3.
Investor gets to keep some more money and pay lesser taxes. 96.9% is received as tax free income. Only 3.9% goes as Tax for 5 years withdrawal.
The benefit tables shown here are for investors who are top tax bracket of 30.9%. STCG taxes are lower for those in lower tax bracket. But DDT rates are fixed everyone.
If an investor is investing money for shorter duration (within 3 years) and plan to withdraw 100% of the capital, go for Dividend Distribution Method.
But if the withdrawal is systematic and will run for several years, regardless of the investor tax bracket, it is always wiser to invest in Growth Scheme with SWP setup. The downside is investor need to end up making capital gain calculations and pay taxes properly in the tax return; there are no TDS. But the extra effort brings in enormous savings to a retiree portfolio.
For retiree portfolio, each Rupee matters and wasting the money in taxes by saving in fixed deposits will destroy the retirement corpus very quickly. Growth Scheme with SWP is the best method for long term withdrawals.