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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:

  1. Investing in a Dividend plan (IDCW): These plans payout a certain amount at regular frequency (monthly, quarterly or annually).
  2. 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:

ParameterIDCWSWP
Payout/Redemption AmountNot fixedFixed by Investor
TDS deducted by AMC7.5%None
NAV of Mutual Fund schemeDecreases by dividend amountNot affected
No. of units in portfolioNot affectedDecreases as per payout amount
Applicable taxesAdded to taxable income & taxed at slab rateSTCG @ 15%

Which one to choose?

Kindly use the interactive spreadsheet below to find out how much returns you can generate in both IDCW & SWP:

Instructions:

  • 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

Fig: IDCW vs SWP returns & taxes paid

IDCW

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.

SWP

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:

Tax to be paid (annually)

= Annual payout x Rate of return x 15%/(1+Rate of return)

STCG Tax rate = 15%

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.

Sayantan Ghosh
Sayantan Ghosh

MBA (Finance), FMVA®