Should you invest in mutual fund dividend option or SWP

Dividend paying mutual funds hold allure for many investors, especially those who want regular cash-flows from their investments. Though many mutual fund schemes have excellent dividend pay-out track records, it is important for investors to understand that mutual fund dividends are not guaranteed. Mutual fund dividends are paid out at the discretion of the fund manager and fund house.

Mutual fund Systematic Withdrawal Plan (SWP) is another option for investors to get fixed cash-flows from their investments. Though dividend and SWP may seem similar there are important differences between the two, which we will discuss in this blog post. Of particular importance is the tax consequence of the two because important taxation changes were announced in last year’s Union Budget.

How do mutual funds pay dividends?

Regular Advisorkhoj readers know that mutual fund dividends are not assured, but a deeper understanding of how dividends are paid will help you make informed investment decisions.

As per SEBI, mutual fund dividends have to be paid from the accumulated profits of the scheme. It is important for investors to understand that accumulated profits must be realized profits. Fund managers cannot pay dividends simply because the NAV has appreciated. He / she can pay dividends only from profits realized by selling stocks at a higher price than the purchase price.

Investors should also understand that the fund manager may not distribute the entire profits booked as dividends. He / she may keep a portion of profits realized in a reserve and only pay a part of the profit as dividends. They do this so that they continue paying dividends from the accumulated profits reserve during periods where the scheme may not have realized profits. If there is no money left in accumulated profits reserve, the scheme will not be able to pay dividends till such time they make profits through portfolio churning.

What is SWP?

In a mutual fund Systematic Withdrawal Plan (SWP), you can draw a fixed amount from your mutual fund investment every month or at any other frequency (specified by the investor); you can specify the amount to be drawn and the day of the month when the withdrawal should be made and the amount will be credited directly to your bank account on the specified day. You can continue your SWP as long as there are balance units in your mutual fund scheme account.

How does SWP work?

Once the SWP in a certain account (scheme) is initiated, it generates cash-flows for investors by redeeming units of mutual fund scheme at specified intervals. The number of units redeemed to generate cash-flows in an SWP depends on the SWP amount and the scheme Net Asset Values (NAV) on the withdrawal dates. Let us understand how SWP generates cash-flows for investors with the help of an example.

Let us assume you invested Rs 10 lakhs in a mutual fund scheme. The purchase NAV was Rs 20; so 50,000 units will be allotted to you. Let us assume you start a monthly SWP of Rs 6,000 after one year from the date of investment to avoid exit loads. In the first month of the SWP, the scheme NAV is 25 (illustrative). In order to generate Rs 6,000 for you, the asset management company (fund house) will redeem 240 units (Rs 6,000 divided by 25). Your balance units will be 49,760 (50,000 minus 240). In the second month, if the NAV is 27, the AMC will redeem 222.22 units (Rs 6,000 divided by 27) for the SWP and your unit balance will be 49,537.78 (49,760 minus 222.22 units). In the third month if the scheme NAV is 28, the AMC will redeem 214.28 units and your unit balance will be 49,323.49. In SWP your unit balance will diminish with each SWP instalment, but if the NAV keeps rising at a faster rate than your withdrawal rate, then you can continue your SWP and at the same time see appreciation in value of the residual units.

Taxation of dividends – Equity Funds

The taxation of dividends has undergone a lot of change over the last few years. Though we in Advisorkhoj have kept our readers posted about the tax changes, here is a brief recap of the taxation of dividends for the benefit of all investors. For the sake of simplicity, we will only cover taxation of equity funds & equity oriented hybrid funds in this post.

Few years back, equity fund dividends were totally tax free, in other words, dividends were tax free in the hands of the investors and the fund house did not have to pay Dividend Distribution Tax (DDT) before distributing dividends to investors. In the 2018 Budget, the Government introduced 10% DDT on equity fund dividends, but dividends continued to be tax free in the hands of the investors.

In the 2020 Budget, the Government abolished DDT but now dividends will be taxed in the hands of the investors based on their income tax slab. So for this financial year (FY 2020-21) and beyond, all mutual fund dividends will be added to your income and taxed according to your income tax slab rate.

For example, if you are in the 30% tax slab, then all mutual fund dividends received by you will be taxed @30% plus applicable cess / surcharge. Income tax computation will be a little complicated this year because you have the option of choosing the new tax regime (with very little deductions) or the old tax regime (with all the applicable deductions). You should consult with your tax advisor with regards to the actual tax consequences of your mutual fund dividends.

Taxation of SWP – Equity Funds

In SWP, cash-flows are generated by redeeming units. If units are redeemed at a NAV higher than purchase price, capital gains taxation applies. Units redeemed within 12 months from the date of purchase will be subject to short term capital gains tax @ 15%. Financial advisors often recommend that investors begin their SWP at least 12 months after the investment date to avoid short term capital gains tax. Units redeemed after 12 months from the date of purchase will be subject to long term capital gains tax.

Long term capital gains taxation has also undergone some changes over the past few years. Prior to the 2018 Budget (FY 2018-19), long term capital gains were tax free. In the 2018 Budget, the Government allowed up to Rs 100,000 long term capital gains in a financial year to be tax free. Long term capital gains in excess of Rs 100,000 will be taxed at 10%. If you purchased your mutual fund units before 1^st February 2018, the capital gains till 1^st February 2018 will be grandfathered, in other words, the purchase price of your units will be based on 31^st January 2018 NAV of the scheme, irrespective of the price you bought the units.

Suggested reading: Know your mutual fund taxation for FY 2019-20

Tax advantage of SWP over dividends

An important part for investors to note about in SWP taxation is that, unlike dividends, the entire SWP proceeds will not be taxed – only the capital gains portion will be taxed. For example, let us assume that the purchase NAV of your scheme is Rs 100 and the redemption NAV is Rs 120. You redeemed 1,000 units to generate a cash-flow of Rs 120,000. Out of this Rs 120,000 only Rs (120 – 100) X 1000 units = 20,000 will be subject to long term capital gains tax.

Over a period of time in your SWP tenure, the long term capital gains portion will increase with rise in NAV, but even then it will be much lower than dividend taxation, for investors in the higher tax brackets, because long term capital gains will be taxed at only 10% after the Rs 100,000 exemption, while dividends will be taxed as per your tax rate e.g. 30% for investors in that bracket.

Conclusion: Which is better - Dividends or SWP?

There are pros and cons of both depending on your financial situation and investment experience:-

• Dividends are not assured but in SWP you get fixed cash-flows irrespective of market situation and NAV movements.


• You have more control in SWP. You decide how much cash-flow you get. Mutual fund dividends, as mentioned before, are paid at the discretion of the fund manager. Sometimes you may get more dividends than what you want, sometimes you may get too less. Both are undesirable.


• In a prolonged bear market, the fund manager may simply stop dividends. You will continue to receive SWP cash-flows even in prolonged bear markets but it will come at a cost. If the NAV falls substantially, the fund house will have to redeem more units to keep the SWP cash-flows going and your unit balance will diminish at a faster rate. This may harm your financial interests in the long term.


• From a taxation viewpoint, for investors in the higher tax slabs, SWP is a clear winner over dividends.


• One of the most important points about SWP is that the withdrawal rate should be lower than the average long term return of the scheme, if you want to continue your SWP for a long time. The withdrawal rate will also depend on what you really need. You should consult with your financial advisor to plan your SWP according to your needs.