Have you ever thought about creating a source of passive income from your investments? Do the high level of taxes on this passive income trouble you? If yes, then this article is perfect for you.
Need for a Secondary source of Income
An ambitious young person has recently taken a home loan for which he needs to pay ₹50,000 per month as EMI. After recurring expenses, he’s left with only ₹30,000 from his salary (primary source of income) to contribute towards this EMI repayment. He’s received a lumpsum amount of ₹25 lakhs from his parents which he now wishes to invest in Mutual Funds to make up for the EMI deficit (₹20,000). So, what options does he have to create a regular passive income?
Redemptions in Mutual Funds
There are 2 ways in which you can set up a regular passive income from your Mutual Fund investments:
- Investing in a Dividend plan (IDCW): These plans payout a certain amount at regular frequency (monthly, quarterly or annually).
- Create a Systematic Withdrawal Plan (SWP) arrangement: This is a direct/regular growth plan with an additional investor instruction such that a specific amount is paid out of your portfolio at regular frequency.
You must be confused, right? Let’s look at the differences between IDCW & SWP in the table below:
|Payout/Redemption Amount||Not fixed||Fixed by Investor|
|TDS deducted by AMC||7.5%||None|
|NAV of Mutual Fund scheme||Decreases by dividend amount||Not affected|
|No. of units in portfolio||Not affected||Decreases as per payout amount|
|Applicable taxes||Added to taxable income & taxed at slab rate||STCG @ 15%|
Which one to choose?
Kindly use the interactive spreadsheet below to find out how much returns you can generate in both IDCW & SWP:
- Set the Zoom level as per your convenience (85% should work fine for most screen resolutions).
- Enter your desired input values (lumpsum amount, expected returns, monthly requirement & current monthly contribution in the designated fields (cells highlighted with green color).
Interpreting the Results
In case of IDCW, the entire dividend/payout is considered as income and is taxed in 2 stages:
- Tax Deducted at Source: Income above ₹5,000 is subjected to a flat tax rate of 7.5%, deducted by the AMC (MF company) even before paying out to your bank account.
- Tax payable on Total income: The entire IDCW payout adds to your annual income (taxable component of salary) and is taxed as per applicable slab rate (20% in most cases & even 30% in a few).
Thus in IDCW, on an annual payout of ₹300,000, the applicable tax is ₹60,000, which drastically reduces after-tax returns.
A SWP is similar to buying & selling a stock for capital gains. Therefore, you pay taxes only on the capital gains and not the entire payout. The formula to calculate your tax liability in a SWP is as follows:
For an investment of ₹25 lakhs with an annual return of 12%, a SWP results in tax liability of just ₹3,857 v/s a massive ₹60,000 tax liability in case of IDCW. This in turn results in a comparatively much higher return through SWP w.r.t. IDCW. Going forward, always decide to go with a SWP arrangement if you’re planning to set up a secondary source of income.