Best way to setup an income in retirement

Retirement is a phase change one will need to get used to. Many of us have lived very busy lives and have been quite active in our careers. The whirlwind activities suddenly come to a halt after retirement.

With retirement, there is a sudden void. Many even keenly feel a loss of status, prestige, and the feeling of importance that they had enjoyed while in the job. In retirement, no one is calling them or conferring with them.  It looks like a fall from grace.

Some people anticipate the spare time and nicely plan what they will do in retirement. All of us need to do that so that this innings is interesting, meaningful, and enjoyable as well.

Money inflow – The other disconcerting aspect is that, while working, one is used to getting an inflow by month end. For most, the inflow is good and there is sufficient liquidity in the bank account at all points. Now, that will change.

The inflow would stop and the sufficient float in the bank account which was taken for granted, will cease to be there (unless the liquidity is planned properly). An income would need to be setup in the retirement phase, to the extent required. There may be many sources of income already on – like rental incomes, pensions, investment incomes, royalty in some cases etc. If that income is not sufficient, further inflows can be setup.

Taxes give a white fright! –  When in retirement, there is another matter that is troublesome. Taxes. People do not mind paying taxes (there is anyway no alternative!) when they are in the working phase. However, when they retire, they do not want to pay any taxes, ideally. But that is not possible as any income earned in any form like interest, coupon, annuity etc. are taxed. 

Taxes affect the post-tax realisations and hence we need to be mindful of taxes, especially when setting up income in post-retirement phase.

But there are ways to reduce the taxes paid even for those people who will be in the 30% plus tax bracket. In fact, that is what we are going to discuss in this edition.

The magic called Systematic Withdrawal – You could invest in debt MFs and setup withdrawals from that. These withdrawals can be to the extent of the interest income that one generates. The taxation in such a situation will be low as it is subject to capital gains tax treatment vs income tax treatment.

Let us consider an example.

Let us say we invest Rs.10 Lakhs in ABC Corporate Bond Fund. For illustration purposes, NAV at the time of investment is Rs.100 & hence the number of unis allotted is 10,000. Let us assume that this fund can offer a 6% annualised return ( we assume steady straight-line returns along the year ).

After three months, the fund would be valued at Rs.10,15,000. Let us say we want to withdraw the amount earned ( Rs.15,000 ).

The amount of money withdrawn would be seen in the form of units withdrawn to that extent.

For that we need to calculate the NAV at that time. That would be Rs.101.5 (Rs.10,15,000/10,000 units)

So the number of units being redeemed for taking Rs.15,000 = Rs.15,000/101.5 = 147.78 units.

Original cost of these units = 147.78 x 100 = Rs.14,778

Short term capital gains = Rs.15,000 – 14,778 = Rs.222

Short-term capital gains tax = Rs.222×30% = Rs.67

Had the same income been generated through a bank or corporate FD, the tax would have been Rs.15,000×30% = Rs.4,500

Effective tax using the Systematic withdrawal method = Rs.67/Rs.15,000 = 0.44%

That is how low the taxes will be when we use Systematic withdrawal from Debt MFs. It’s almost like magic!

Advantages of Systematic Withdrawal –

• One can withdraw in any frequency (monthly, quarterly, half-yearly, annually) as per the need.
• Amount to be withdrawn can be decided by us (should be ideally at or below the earnings of the fund so that it can sustain in perpetuity)
• One can stop the withdrawals temporarily; one could increase or decrease it based on our requirements.
• Very tax efficient, even if withdrawn within three years, as shown in the above example. If withdrawn after three years, it comes under long-term capital gains dispensation. In long-term capital gains, one can take advantage of indexation & then pay 20% tax on the difference between sale price of units and indexed cost of units. The effective taxation will probably be about one third of the one shown above or about 1.3-1.5% only
• The underlying advantages of investing in a debt fund like diversification of the underlying papers, liquidity, fund manager oversight, lower risk (if funds are chosen well) also comes with the territory.

Things to keep in mind – While setting up debt funds we should set up the withdrawal rate lower than what the fund generates. That way, the principal will not erode.

In times like these when realisations from the funds themselves are low one should set the withdrawals low so that they do not erode the capital. Later when the tide turns and the fund generates a higher interest rate, the withdrawals can be increased.

What kinds of funds would work – Currently, one may consider Corporate bond funds, Dynamic Bond Funds and Banking and PSU debt funds. One may also consider Short term funds and even medium term funds ( if their duration is three years or less ).

As much as possible we can choose lower effective durations of between 1.5 -2 years (going up to a maximum of 3 years) of the underlying papers (this information is publicly available for every fund).

We are choosing lower durations as there is a chance of interest rate increases in times to come. When we choose a fund with short tenure underlying papers, the reinvestments as they mature can be in higher interest levels. Hence, this may be suitable for now.

If one wants to invest in longer duration funds with a view to setup the systematic withdrawal after a few years, that will work well too.

Should everything be this mode – No. There are people who may want the safety of a certain return, like in the case of Bank FDs, NCDs, Bonds etc. For them, those kinds of instruments would be better, inspite of the higher tax incidence.

In some cases, people do not come into the higher slabs or do not come into the tax slabs at all. They could invest in FDs, NCDs, Bonds etc.

How much should be done in which instrument needs to be carefully considered in every case before suggesting investments.

Our take – Some of you have asked why we prefer Systematic withdrawal from a debt fund. While I have explained individually, I thought that it maybe a good idea to explain this to all so that this area becomes clear.

Systematic withdrawal is a very useful tool to setup an income and is very tax efficient and flexible. Hence, we depend on this a lot for income setup in the retirement phase.

We don’t have the power to do away the tax; we can however reduce it greatly using this method.