If you are looking to generate monthly or regular income, then this is a must read for you.
People who need a regular income look for safe options like bank fixed deposits. However, taxes and inflation reduce the purchasing power of their monthly income. Retirees may find it hard to make ends meet. They could even run out of money at a time when it’s not possible to earn more.
A downward trend in the interest rate can also reduce the income, and this can add to the problem. Retirees who are in the highest income tax bracket lose a significant part of their income to taxes. Interest earned on bank fixed deposits is fully taxable.
Retired people need to explore other investment options that provide higher returns. The aim is to get post-tax returns that are higher than the rate of inflation. Debt funds and hybrid funds can offer higher, and they are not as risky as equity mutual funds.
Consider your age, risk tolerance, monthly expenses, investment period and taxes before investing.
Let’s take a closer look at the various categories of mutual funds that can provide a regular income:
Using debt funds to generate a steady income
Debt funds may not be as safe as bank fixed deposits, but they are a lot safer than pure equity mutual funds. However, debt funds can also suffer losses. This can happen if they invest in bonds with low credit ratings or make the wrong duration calls.
It’s best to stick to the safest types of debt schemes, such as liquid funds and ultra-short funds. Safety is their main priority, and they invest in AAA-rated short-duration instruments.
Liquid funds invest in debt and money market securities with a maturity of up to 91 days. These funds are the least risky, and they have been providing returns of 7% to 9% per year.
Ultra-short-duration funds invest in debt and money market instruments. The Macaulay Duration of the instruments is 3-6 months. They are riskier than liquid funds, but they provide higher returns than them.
Low-duration funds invest in debt and money market instruments. The Macaulay Duration of the instruments is 6-12 months. They are riskier than ultra-short funds but they offer higher returns than them.
Short duration funds invest in debt and money market instruments. The Macaulay Duration of the instruments is 1-3 years. They are suitable for investors who are investing for a longer period and can take on a little more risk.
Long duration funds, gilt funds, dynamic bond funds, and credit risk funds are riskier. They are suitable for investors who are looking for higher returns.
Using hybrid funds to earn a regular income
Hybrid funds or balanced funds invest a part of their assets in equities and the rest in debt. The equity part helps to boost returns, and the debt part limits the downside when the market falls. They offer higher yields than pure debt funds. At the same time, they are less volatile and risky than equity funds.
Aggressive hybrid funds invest between 65% and 80% of their assets in equities and the rest in debt. This helps them to qualify for tax benefits provided to equity mutual funds. They are for investors who can take more risk to get higher returns. However, some hybrid funds are almost as volatile as pure equity funds.
Balanced advantage funds also invest in a mix of equity and debt. They practice dynamic allocation based on market valuations. The equity exposure usually varies from 30% to 80% or even more. When valuations are high, they reduce their equity exposure. They do this by taking arbitrage positions through equity derivatives. This allows them to qualify for tax benefits provided to equity funds.
Monthly Income Plans (MIPs) are in the conservative hybrid fund category. They invest between 75% and 90% of their assets in debt instruments. The rest is invested in equities and equity-related instruments. This helps to limit the risk but the return is also a lot lower than equity-oriented hybrid funds.
MIPs provide a monthly dividend only if there is a surplus income to distribute. They are in the debt fund category. Returns on withdrawals within 3 years are subject to short-term capital gains tax. Investors add the gains to their income for taxation.
Systematic Withdrawal Plan (SWP) vs. dividend option
You can select the growth option of a debt fund or hybrid fund and set up a Systematic Withdrawal Plan (SWP). This will provide a fixed sum at regular intervals in a tax-efficient manner. You can set up an SWP to withdraw a fixed amount every month, quarter or year. Another option is to withdraw only the gains at a fixed interval.
The dividend option pays out gains made by a mutual fund at regular intervals. However, the dividend is not assured. The mutual fund may skip it at times when there are no gains. This may not suit retirees who need a regular income.
Dividend paid out from debt funds is subject to Dividend Distribution Tax (DDT) @ 28.84%. The dividend is tax-free in the hands of the investor. Although the fund house pays the DDT, it is borne by the investor.
SWPs from debt funds have different tax rules. Withdrawals within three years are subject to Short-Term Capital Gains Tax. Investors have to add the gains to their income while calculating the tax. Withdrawals from debt funds after three years are subject to Long-Term Capital Gains (LTCG) tax @ 20%. The indexation benefit is available.
Equity-oriented hybrid funds have different tax rules. Withdrawals within one year are subject to Short-Term Capital Gains Tax @ 15%. Withdrawals after one year are subject to Long-Term Capital Gains (LTCG) tax @ 10%. The indexation benefit is not available. Gains of up to ₹1.0 lakh per year are tax-free.
Debt and hybrid mutual funds offer higher post-tax returns than bank fixed deposits. However, the level of risk is a little higher. An SWP is better than the dividend option because it provides a regular income and is more tax efficient.