Should I switch to dividend funds or SWP for passive income?

Ans: Let’s take a close look at both Systematic Withdrawal Plan (SWP) and Dividend Payout options to understand how they compare.

The goal is to evaluate them on various factors like capital safety, income consistency, tax impact, and long-term growth.

Systematic Withdrawal Plan (SWP): A Structured Cash Flow
An SWP allows you to withdraw a fixed sum regularly from your mutual fund investment. This gives you steady cash flow, often monthly, quarterly, or yearly. With SWP, the withdrawal amount is entirely in your control.

The capital remains invested, growing at the prevailing rate. Only the amount you withdraw comes out of your investment. This allows you to benefit from market gains, while also receiving regular cash flow.

An important point to remember here is that, unlike dividends, the SWP allows you to decide the withdrawal amount based on your needs.

In this sense, SWP provides both flexibility and control.

Dividend Payout: Irregular and Uncertain Income
In the Dividend Payout option, the mutual fund company declares dividends based on the surplus generated. The frequency of dividends depends on the fund’s performance and the fund manager’s decision. This means you do not have control over the payout amount or the timing of the dividends.

Dividends are only distributed when the fund makes a profit. So, while there may be periods where you get regular income, there could be times when you receive nothing. This irregularity makes dividend options unreliable for long-term income planning.

Key Factors to Compare

Let us compare SWP and Dividends based on key factors like capital depletion, income certainty, and tax efficiency.

Capital Safety: Myth vs Reality
SWP: You mentioned that an SWP may drain the capital over time. While this is technically true, it depends on the withdrawal rate and market performance. If you withdraw too much, too quickly, the fund could deplete. However, with a balanced withdrawal approach and a diversified portfolio, the capital can last longer while still growing.

Dividend Payout: On the other hand, it is a myth that the capital remains intact in dividend-paying funds. When dividends are paid out, the Net Asset Value (NAV) of the fund reduces. This reduction in NAV affects your total investment value. You may not be withdrawing capital directly, but dividends are reducing your investment’s potential for growth.

Hence, neither option guarantees capital safety.

Income Consistency: SWP Gives You Control
SWP: With an SWP, you can plan your cash flow according to your financial needs. You decide the withdrawal amount, and it remains consistent regardless of market performance. This is particularly helpful for retirees or those seeking regular income.

Dividend Payout: Dividends, as mentioned earlier, are uncertain. Even funds that have a history of paying regular dividends may not continue to do so in the future. Economic conditions or fund performance can influence this, leaving you with inconsistent income.

Long-Term Growth: SWP Keeps You Invested
SWP: In an SWP, most of your capital remains invested, allowing you to benefit from market growth. As long as your withdrawal rate is moderate, the remaining corpus continues to grow. Over time, the power of compounding can help replenish your withdrawn amounts.

Dividend Payout: With dividends, your returns are distributed, reducing the amount that stays invested. This hampers the compounding effect, leading to lower long-term growth potential compared to SWP.

Tax Implications: How the Rules Have Changed
SWP: In an SWP, withdrawals are treated as partial redemption. The taxation depends on the holding period and the capital gains tax rules. Long-term capital gains (LTCG) tax is lower if you hold equity funds for more than one year. Short-term capital gains tax (STCG) applies if the holding is less than a year.

Dividend Payout: Dividends used to be tax-free in the hands of investors. However, this has changed. Now, dividends are taxed according to your income slab. This makes dividends less attractive from a tax perspective, especially for those in higher tax brackets.

Given the dynamic nature of tax laws, relying on dividends solely for tax benefits is not advisable. SWP offers better tax management, as you can control when to sell and reduce tax impact by holding investments long-term.

Why SWP Is a Better Choice

Now that we have compared both options, here’s why SWP can be more advantageous over dividend options.

Flexibility and Control Over Withdrawals
You get to choose the withdrawal amount and frequency.

Unlike dividends, which depend on the fund’s performance, you are in charge.

This control is valuable for financial planning.

Consistent and Predictable Income
SWP provides steady income, unlike the irregularity of dividend payouts.

For those who need consistent cash flow, SWP is more reliable.

Market Participation and Growth
The corpus in SWP continues to grow, whereas in the dividend option, part of the growth is paid out regularly.

Over a long period, SWP allows you to take advantage of market growth.

Better Tax Efficiency
SWP can be tax-efficient as compared to dividends.

With SWP, capital gains tax applies only on the amount withdrawn, not the entire investment.

Addressing the Misconceptions Around Capital Depletion

It’s important to address your concern about SWP draining the capital. While the fund value can go down, this is true for all investments based on market performance.

In the case of dividend-paying funds, the fund value also reduces whenever dividends are declared. The only difference is that you don’t have control over how much or when the payout happens.

With proper planning, the chances of depleting your corpus through SWP can be reduced. The key lies in determining a sustainable withdrawal rate based on your investment’s growth potential.

Balanced Approach Can Help
A balanced portfolio with a mix of equity and debt funds can help in maintaining capital for a longer time while allowing you to withdraw regularly.

You can consult with a Certified Financial Planner to review your portfolio, withdrawal rates, and future needs.

Final Insights
In summary, while dividends may seem like a safer option, they come with unpredictability and tax challenges. SWP offers greater control, better tax management, and the potential for long-term growth.

By carefully choosing the withdrawal rate and monitoring the investment, SWP can meet your needs for regular income without unnecessarily depleting your capital.

It offers a far more predictable income stream and keeps you invested in the market for growth.

Best Regards,

K. Ramalingam, MBA, CFP,
Chief Financial Planner,
www.holisticinvestment.in
Instagram: https://www.instagram.com/holistic_investment_planners/