The 10% tax on all equity mutual fund dividends is a blow to all those who sold and bought funds that offered monthly dividends. This is a blessing as it would reduce mis-selling and hopefully mis-buying, but begs the question: is it possible to generate tax-free regular income from mutual funds? The answer is yes – but only for those who can afford to do so. I discuss two examples of generating regular income from arbitrage mutual funds.
The first example will result in 10% LTCG tax after a few years for those who have income from other sources above the tax-free limit. For those with income less than taxable limit or no income from other sources, this LTCG tax also can be avoided (to an extent).
The second example will adjust withdrawals to avoid LTCG tax for all years.
The main idea behind these examples is to point out how LTCG tax works and how we can minimise it to a certain extent, but cannot escape from it(unless you withdraw less and less). I consider a single arbitrage mutual fund and no other source of equity. In a real portfolio with multiple sources of equity, LTCG calculation before I withdraw is a little messier.
Warning: Withdrawals from mutual funds will reduce the no of units held. There is no concept of interest income in mutual funds. I would strongly advise you to read this post before proceeding: Do you know what happens when money is redeemed from a mutual fund?
Note 1: Never make regular withdrawals from a volatile mutual fund. If the NAV decreases, then for the same amount redeemed, more units will be reduced and your value will drop faster. Therefore use only debt mutual fund or arbitrage mutual funds for withdrawals (regular or otherwise).
A retiree could use dividend option of equity mutual funds (including balanced funds – not monthly dividend) for automated tactical profit booking (say twice a year with DDT on each dividend) or could book profits on their own (and avoid tax if the CG is less than a lakh). That is tactical withdrawals are perfect from volatile instruments for income generation.
What are arbitrage mutual funds?
These are funds that invest in equity but buy & sell the same stock in different markets to benefit from the difference in prices. As long as they buy and sell only the same stock, the risk is more than a liquid fund and similar to an ultra short-term fund. Please consult these posts to know more:
Arbitrage mutual fund NAVs can fluctuate up and down on a daily basis. They can result in negative monthly or even quarterly returns. The chances of negative annual returns are pretty slim. So they are perfect for an annual withdrawal or even a quarterly withdrawal. Monthly withdrawals can be done cautiously.
Avoid SWP for withdrawals. Redeem what you need, when you need and only the amount that you need. It will take 30 seconds to confirm a redemption! This way you will not end up having extra money and pay unnecessary tax on it (see below).
Example 1: Regular withdrawals
Suppose we invest Rs. 50 Lakh in an arbitrage mutual fund on 1st April 2018 and assume that the NAV increase by 6% each year (a reasonable assumption, at least for next few years).
Let us take on the following table row by row:
1st April 2018: 2,00,000 units are available as the purchase was at a NAV of 25. Now have a quick look at columns 1 (date) and 2 (NAV) and how it grows.
366 days later, on 2-April 2019 The NAV is 26.50. An increase of 6%.
Each year we withdraw an amount equal to (26.50 -25) x units available = Rs. 3,00,000
Now look at the value after withdrawal, the amount withdrawn and value after withdrawal columns. We pull out an amount equal to the annual growth in value.
This will not happen in real-life as we cannot expect a steady 6% return each year.
So we continue such withdrawals each year. Notice how the units before withdrawal steadily decrease. Therefore, even if we withdraw an amount equal to the gain made, the so-called “principal” will steadily decrease. This is the danger with mutual fund withdrawals. You can run out of units to withdraw from! Whereas if you buy an FD or an annuity, the principal will not diminish (just that inflation will degrade its value).
Now, look at the capital gain after each withdrawal. Notice that for the first few years it is well below one lakh (even though withdrawal is 3L), but it quickly creeps up!
Why? Becuase Capital Gain = units redeemed x (final NAV – initial NAV)
Initial NAV = purchase NAV = 25.
As the years’ pass, the final NAV becomes much higher than the initial NAV resulting in higher and higher CG.
If you do not set up a constant SWP, you retain the power to withdraw as much as you like and if possible an amount corresponding to a CG of less than one lakh.
Mutual funds will come up with fancy SWP solutions after the imposition of LTCG tax. Ignore them!
The taxable capital gain in the picture assumes that we have taxable income from other sources for which we pay the slab rate.
IF (a BIG IF) this arbitrage fund withdrawals constitute our only income (a terrible idea!) THEN beyond the 1L tax-free CG exemption, we have another 2.5 L* CG tax exemption
* up to tax-free income limit. 3L for senior citizens
That is, if our CG is 1.5L, then 1L is tax-free. The remaining 0.5L is also tax-free as it is lower than the tax-free limit.
Suppose we have 2L income from other sources, then also the 0.5L CG is tax -free.
That is, income from other sources + CG is less than or equal to 2.5L and hence tax-free.
If we have 3L income, we will fall under 5% slab. In this case, we need to pay 10%(+cess) tax on the 0.5L CG.
Please note income clubbing rules apply. We cannot “invest in the name of” of our spouse and escape tax.
You can “gift” the money to an adult child or parent and invest “through them”. However, be warned that it then becomes “their money”. If you have siblings, they can demand a share if your parents die when holding the investment.
Example 2: Tax-free withdrawals
Suppose we withdraw such that LTCG tax is zero. That is the CG is always less than one lakh.
Naturally, to avoid tax we will have to with less and less and this is impractical unless we use it as an occasional income supplement.
The central point is that you cannot avoid LTCG tax if you wish to withdraw the same (or increasing) amounts and to do avoid the tax, the price you have to pay is lesser money in your hand!
Income only via interest is suitable for those who do not have much of a corpus to work with. See: When should senior citizens purchase an annuity?. Here the income is taxable as per slab and probably in the 0% or 5% slabs.
Income only from withdrawals and stock dividends (which remain tax-free) is suitable only for those who have enough corpus to generate inflation-protected income. In this case, the bulk of the income ought to be from capital gains (else they could be paying 20% or 30% tax)
For a vast majority of people who will be needing income post-retirement at present and for the next few years, a mixture of the above methods is necessary. The interest income route to guarantee say at least 70% of expenses in the initial year of retirement for life and the rest via capital gains. Those in the 5% slab can avoid paying LTCG tax. Those in higher slabs can happily pay the tax as it is still pretty tax efficient.
Using a bucket method, we could have a liquid fund or arbitrage fund as the base from which we draw income for regular expenses and other fixed income and equity buckets which will supplement the base bucket from time to time. You can play the Retirement Bucket Strategy Simulator to see this in action and use the freefincal robo advisory software template to play with a bucket strategy (if you can afford to!)