How Retirees Can Wisely Use the SWP Option Following the 4% Withdrawal Thumb Rule

May 6, 2024 Mutual Fund

“As in all successful ventures, the foundation of a good retirement is planning.” – Earl Nightingale, American speaker and author.

If you plan your retirement well, you will never have to worry about questions such as ‘Will I be able to meet regular expenses after retiring’ and ‘Will my retirement fund last till my last breath?’

When you are nearing retirement, you ought to start thinking about how you are going to draw a regular cash flow or income from your savings and investments you have been making for your retirement.

In this regard, you can’t rely solely on drawing interest income (from bank deposits, small saving schemes, etc.). In times when inflation is spiralling, it may eat into the purchasing power of hard-earned money.

Similarly, one cannot rely solely on dividend income because if the overall business sentiments are unfavourable, the profitability of the company is imperilled, markets turn turbulent, and/or the company consciously decides to plough back dividends to fund its growth; not all shares held in your portfolio would earn you a dividend.

So, how do you ensure a regular flow of money after retirement?

Well, the Systematic Withdrawal Plan (SWP) in mutual funds is an efficient way of getting regular income.

What is SWP in mutual funds?

An SWP (Systematic Withdrawal Plan) option in mutual funds is a facility that enables you to withdraw money from your mutual funds in a systematic manner.

The SWP is a prudent way to regularly withdraw the retirement corpus that you built by investing in mutual funds during the earning phase of your life. Systematic withdrawal also helps you to maintain your current lifestyle even after retirement.

SWP allows you, the investor, to withdraw systematically on predefined dates from your mutual fund investments and hold the potential to clock returns on the remaining investments over a period of time. These withdrawals can occur annually, semi-annually, quarterly, or even monthly.

As the units are not redeemed in one go, you benefit from the power of compounding. This ensures that your retirement money lasts long and is not prematurely exhausted.

These withdrawals could be in the form of a fixed or variable amount. Thus, SWP not only provides you with a regular source of income but also encourages a disciplined approach to managing your finances.

Here are some important features of SWP in mutual funds:

• Systematically cash-in your investment units at regular intervals;
• You can choose the amount, frequency, and start and end dates of the SWP plan;
• You can either withdraw a fixed amount or only the capital appreciation;
• Enables rupee-cost averaging;
• The remaining investments/units would benefit from the power of compounding;
• Helps you to effectively manage your retirement corpus as you will be discouraged from withdrawing large amounts;
• Withdrawal rate can be revisited to accommodate changes in lifestyle or inflation rate.

How does SWP in mutual funds work?

Let us look at an example to understand how a systematic withdrawal plan works.

For instance, you have accumulated a sum of Rs 1,00,000 by investing in a mutual fund scheme over a period of time and want to withdraw a specific amount every month to maintain a regular flow of income.

Now, you decide to set up a SWP plan to withdraw Rs 10,000/- at a specific date of every month. The mutual fund’s Net Asset Value (NAV) is Rs 100/- per unit.

Additionally, when you set up an SWP, you instruct the fund house to release funds at regular intervals (usually monthly, quarterly, or annually). Therefore, these funds get transferred to your bank account automatically.

Now, let’s have a look at the SWP mutual funds return calculation process:

For illustration purpose only.
(Source: Data collated by PersonalFN Research) 

Thus, what SWP does is facilitate piecemeal withdrawals. As you can see, on each monthly withdrawal, the value of your investment in the fund is reduced by the market value (NAV) of the units that you have withdrawn, while the remaining mutual fund units will clock returns for you.

How much should you withdraw via SWP to meet your post-retirement needs?

For withdrawals, retirees can opt for the 4% withdrawal thumb rule. This general rule of thumb suggests that withdrawals should be capped at 4% per annum of the accumulated retirement corpus to ensure a peaceful retirement.

Why 4%? Why not 5% or 6%? you may ask. The below illustration will help you understand better.

Calculating retirement corpus by using the thumb rule of 4% withdrawal

For illustration purpose only.
(Source: Data collated by PersonalFN Research) 

Assuming your monthly expenses currently are at Rs 60,000, inflation is 6% per annum on average, and you have 5 years before you hang your work boots; your monthly expenses are likely to increase to approx. Rs 80,000 (annually around Rs 9.60 lakh) so, doing a backward calculation your retirement corpus must be at least Rs 2.41 crore.

Click here to calculate your retirement corpus.

If the withdrawal rate is set at 4%, as seen in the table below, the corpus comfortably lasts until the age of 96 years as the balance corpus after each year of withdrawal earns a modest 8% per annum while the inflation on an average is 6%.

Impact of withdrawing at 4%

For illustration purpose only.
(Source: Data collated by PersonalFN Research) 

When you increase the withdrawal rate to 6%, the corpus lasts you even shorter: to be precise till 80 years of age. In other words, the corpus will last 16 years less than had you withdrawn the corpus following the 4% thumb rule.

Impact of withdrawing at 6%

For illustration purpose only.
(Source: Data collated by PersonalFN Research) 

So, the key takeaway here is that when you withdraw excessively from the retirement corpus, there is a risk of outliving the money needed to meet your retirement expenses. Thus, never commit the mistake of utilising your retirement corpus to make big-ticket purchases, such as expensive jewellery, artefacts, or buying a second home unless you have an ample amount of wealth that ensures a very blissful retirement.

What are the tax implications of SWP?

From a taxation viewpoint, do note that withdrawal may be subject to capital gains tax.

The gains on your equity mutual fund investments if withdrawn in the first year are treated as Short Term Capital Gains (STCG) and taxed at 15%. If the investment is redeemed after the first year, the gains are called Long Term Capital Gains (LTCG) and are taxed at 10%, if the gains exceed Rs 1 lakh.

If you have invested in a debt mutual fund and opted for SWP. The net gains get added to your income and taxed as per your tax slab.

To conclude:

It is important to carefully plan how will spend your retirement corpus keeping in mind your lifestyle and the accumulated corpus. If you make unplanned lump sum withdrawals, it can have a detrimental effect on your investments. You may end up exhausting your corpus earlier than expected if the rate at which you are withdrawing from your mutual fund plan is higher than the rate at which the scheme’s NAV is growing. Hence, in order to meet your liquidity needs, prefer a disciplined approach by opting for systematic withdrawals.

Watch this video to know about the four best mutual funds types for planning your retirement:

This article first appeared on PersonalFN here