By Dhirendra Kumar

With the stressful growth situation continuing, higher interest rates are unlikely to be seen any time soon. This means smart savers need to think clearly about using equity-based mutual funds as a source of regular income. The realisation that bank fixed deposits are a poor way of earning an income hasnt come a day too soon. On an inflation adjusted basis, fixed deposits (and other interest-bearing assets) were always a bad bet. In reality, for deriving a regular living income, specially for long periods as in retirement, equity mutual funds or balanced funds are by far the best option.

Every kind of logic points to this: One, a lower tax rate. Two, taxation only on withdrawal. And three, higher returns. Taken together, this effectively closes the argument. Lets see how.

Lets examine fixed deposits first. Suppose you have Rs 1 crore as savings from which you need a regular income. In a bank FD, a year later, it will be Rs 1.07 crore. So you have earned Rs 7 lakh, effectively Rs 58,000 a month, right? Only in theory. Assuming an inflation rate of 5%, if you want to preserve the real value of your Rs 1 crore and continue earning for years, you must leave Rs 1.05 crore in the bank. That leaves Rs 2 lakh for you to spend, which is just a paltry Rs 16,666 a month! This means that if you need Rs 50,000 a month, you need Rs 3 crore. Of course, at that level, income tax also kicks and about Rs 30,000 a year will have to be paid. Its actually even worse, because the tax has to be paid whether you realise the returns or not.

The situation is different when, instead of receiving interest, you are withdrawing from an investment in a hybrid (balanced) mutual fund. Unlike deposits, these are high-earning but volatile. In any given year, the returns could be high or low, but over five to seven years or more, they comfortably exceed inflation by 6-7% or even more. For example, over the past five years, a majority of equity funds have given returns of 12-14% or more. The returns may have fluctuated in individual years, and thats something that the saver has to put up with, but this is the way to defeat the threat of old age poverty.

In such mutual funds, one can withdraw 4% a year and still have a comfortable safety margin. On top of that, the tax is much lower. Instead of being added to your income, as with interest income, you have to pay capital gains tax on withdrawal. As long as the period of investment is greater than one year, returns from equity funds are taxed at 10%. So for a monthly income of Rs 50,000, Rs 1.5 crore will suffice instead of Rs 3 crore as with FDs. And no matter how high your savings and expenditure, its still taxed at 10%.

However, the tax advantage has yet another hidden factor. Lets say you invest Rs 10 lakh in a mutual fund. A year later, the value of the investment increased to Rs 10.80 lakh. Now, you want to withdraw the Rs 80,000 you have gained. In your holding, 7.4% is the gain and the rest (92.6%) is the original amount you invested. When you withdraw any money, the withdrawal shall be considered (for tax purposes) to consist of the gains and the principal in this same proportion. Therefore, of that Rs 80,000, only Rs 5,926 will be considered gains and will be added to your taxable income. Obviously, this makes a big difference in the tax you pay.

The conclusion is clear: in every possible way, it is better to draw your earnings as regular withdrawals from an equity mutual fund, rather than as interest income. The SWP (Systematic Withdrawal Plan) facility is available for regular withdrawals from every open-ended fund. The volatility may be a little uncomfortable in the short-term, but the maths and the logic are crystal clear.

(The writer is CEO, Value Research)

See original here:
How to earn regular income by investing in mutual funds - Economic Times