Intermediate

Amended as on Apr 1, 2023: Please note that as per amendments in Finance Bill 2023, from April 1, 2023, profits made on investments in debt mutual funds are now taxed as short-term capital gains if these funds invest <=35% in equities. This means, debt mutual funds are now taxed as per the income tax rates as per an individual’s income.

Also note that with effect from Apr 1, 2020, Dividend Distribution Tax (DDT) was abolished, and mutual fund dividends were made taxable in the hands of investors. Dividend income is now considered as ‘income from other sources’ and investors need to pay tax on it as per their individual tax slabs.

This article is currently in the process of getting updated, as it was originally written at a time when tax rules were different. Please treat this note as the latest updated tax information in the meanwhile.

Systematic Transfer Plans (STPs) and Systematic Withdrawal Plans (SWPs) are investment tools available to mutual fund investors to help them invest more systematically, effectively and strategically.

About Systematic Transfer Plans (STPs)

You can use a Systematic Transfer Plan (STP) to invest a lump sum amount in one scheme and periodically (monthly, quarterly, etc.) transfer a pre-defined amount from that scheme into another scheme on a pre-specified date. A smart choice for those investors who wish to manage risk over the long term, STPs work especially well during times of volatility as they allow you the advantage of systematic, automated and periodic transfers without the need for any additional action.

Effective use of a STP

Under STP, a lump sum amount can be invested in a debt-oriented fund and periodic transfers are made into an equity-oriented fund as a protection against immediate stock market volatility and slow exposure to a slightly more risky asset class. This will ensure regular transfers to the equity fund while the corpus in the debt-oriented fund keeps accumulating returns. The benefit of STP is clear from the example below:

Result of using an STP:

Result of investing only in equity fund:

As you can see from the first table above, the investor has moved a fixed amount i.e. Rs. 5,000 every month from a debt-oriented fund into an equity fund. While he continues to earn returns in the debt-oriented fund, he is also benefiting from gains accruing in the equity fund. Now even if the investor were to make a marginal loss in the equity fund, his debt-oriented investment would still have covered partly or fully for such a loss.

In contrast to this, as seen in table 2, strategy, if the investor had invested the original lump sum amount of Rs. 100,000 directly into an equity fund at the start of his investment plan, he would have experienced erosion in his capital due to market volatility. Thus, an STP can actually be a superior strategy than lump sum investing in equity, and is a great hedge against market volatility.

A point to note:
Investors can choose to transfer a fixed sum periodically using a STP or just the capital appreciation from one fund to another.

Using STP for one’s retirement needs

A person approaching retirement can use STP in a reverse manner, that is, transfer a pre-determined amount periodically from an equity fund into a debt-oriented fund. This serves two purposes – it helps fund one’s retirement needs and helps reduce the risk associated with equity investment as one nears retirement.

Are there different kinds of STPs?

Yes, today many mutual fund houses have started offering different ways of starting an STP, which are flexible and respond to different market situations automatically. Some may have a feature that allows your monthly transfer amounts to increase automatically if the market falls and others may have the feature to allow your transfer amounts to increase or decrease based on market movements while also readjusting the overall transferred amount to limit asset class exposure over a desired level.

How are STPs taxed?

An STP transaction is treated like a redemption from the fund you are transferring amounts from (also called the source fund), and a fresh investment into the fund you are investing in (also called the destination fund) for tax purposes.

STP from Specified Mutual Funds
If the source fund is not an equity-oriented fund (that has no more than 35% of its assets invested in domestic equity), and if the investment was made prior to April 1, 2023, then short-term capital gain taxes will apply in case the transfers are carried out within 3 years of the initial investment; in such a situation, you will be taxed according to the income tax slab applicable to you. If the transfer is made after holding the investment for at least 3 years, then any gains will be taxed at 20% with indexation benefits.
However, if the investment were made after April 1, 2023, then any capital gains on it will be deemed as short term and will be taxed according to the tax slab applicable to you.

STP from Non equity oriented fund which is also not a specified mutual fund

If the source fund is not an equity-oriented fund (i.e. it has more than 35% but less than 65% of its assets invested in domestic listed equity), then short-term capital gain taxes will apply in case the transfers are carried out within 3 years of the initial investment; in such a situation, you will be taxed according to the income tax slab applicable to you. If the transfer is made after holding the investment for at least 3 years, then any gains will be taxed at 20% with indexation benefits.

STP from equity oriented fund

Capital gains earned on redemption from the source fund, which is an equity oriented fund, will be taxed at a rate of 10% for capital gains exceeding Rs 1 lakh for a financial year, provided that the investment in the source fund was held for at least 12 months; otherwise, tax at a rate of 15% will be payable on any gains if investment in source fund was held for less than 12 months.

About Systematic Withdrawal Plans (SWPs)

A Systematic Withdrawal Plan (SWP) is a tool that allows you to withdraw a fixed amount of money at pre-specified intervals. The money you withdraw can be held by you in cash or reinvested. SWPs are a smart choice for those investors who wish to invest today to earn capital appreciation on their saved up money but also seek a periodic income over the long term.

Effective use of a SWP

You can use a SWP to generate regular income; this is especially for those who are looking to plan for their retirement years, or fund some other activity that requires a fixed amount of money at regular intervals. SWPs make sense because:

• You get an income irrespective of gains or losses on your investments. This is called fixed withdrawal.
• You have the option to set up a SWP in such a way that only gains on investment are withdrawn regularly. This is called appreciation withdrawal.

As an example, let’s consider an investor who wants an income of Rs. 1,000 per month. He invests in 2,000 units of an SWP equity mutual fund at a NAV of Rs. 10. This means that his total investment is Rs. 20,000. Moreover, let’s assume that for the time period under consideration, the average monthly rate of return is 1%.

In the above example, the investor is taking out a regular income from his mutual fund, and irrespective of market movement, he is able to keep withdrawing a fixed amount of money.

How are SWPs taxed?

A SWP is nothing but redemption of units from the scheme; the tax treatment of each withdrawal will be the same as in the case of STP given above depending upon the category to which they belong i.e. Equity Oriented Funds (exposure to domestic listed equity shares more than 65%), Specified mutual Funds (exposure to domestic equity shares upto 35%) and non equity oriented funds other than specified mutual funds (exposure to domestic listed equity shares more than 35% but less than 65%).