Systematic Investment Plan (SIP)

Systematic Investment Plan (SIP) – the time-tested method to multiply your money!

The Indian stock market is synonymous with volatility and dynamism. What is the strategy for investors like you and me to sail smoothly in a storm? Past experiences have shown that a disciplined investment plan holds the key to ride bulls and bears in the market. One of the most convenient methods of investing in the stock markets is the SIP. SIP is a powerful tool, with a strategy of not only preserving capital but also translating into substantial creation of wealth in the long run.

What is a Systematic Investment Plan ?

SIP is a method of investing a fixed sum, regularly, in a mutual fund. A SIP allows you to buy units on a pre-determined date at pre-determined intervals at the prevailing NAV on that day. Once you have decided the mutual fund scheme in which you want to invest and on the amount you want to invest and the frequency of investment (monthly or quarterly), you can either give post-dated cheques or ECS instruction, and the investment will be made regularly. SIPs generally start at minimum amounts of Rs 500 per month and the upper limit for using an ECS is Rs 25000 per instruction. Therefore, if you wish to invest Rs 1,00,000 per month, you may need to do it on 4 different dates.Think of each SIP payment as laying a brick. One by one, you will see them transform into a building. You will see your investments grow steadily month after month. Being disciplined is, no doubt, the key to successful investing.

Exploding the myths on SIP

The seemingly simple SIP has been one of the most misunderstood concepts associated with mutual fund investment. Let us now break some myths associated with SIP.

Investment in equity mutual funds should always be done in SIP mode: If you have the maturity and serenity to realize that equities are for the long term and are willing to leave your funds untouched for about 10 years and you have a substantial sum, you can afford to give the SIP route a slip. However, if your horizon is less than five years, SIP is the best alternative.

Rupee cost averaging in a single equity is a kind of SIP : Rupee cost averaging in a single scrip cannot be equated to a SIP. When the market brings down the price of a single scrip, it is giving you information. You need to react to that. Silverline Technologies moved from Rs 30 to Rs 1300 and then to Rs 7! In this case, if you had started a SIP at a price of Rs 1300, today you would be licking your wounds. SIP works in a portfolio (hence a mutual fund) and not in a single scrip.

You cannot invest a lump sum in the same account in which you are doing a SIP: Many people assume that if they are doing a SIP in a particular fund and they have an unexpected surplus, they cannot put that amount in that account.The fact is, in case you are doing a SIP of Rs 10,000 per month in an equity fund and suddenly you have a surplus of Rs 100,000 and you have a 10-year view on the same, then you can just add it to your SIP account. SIP is just a payment mode, not a scheme!

Fear of procecution in the event of non-payment of a monthly investment: In a SIP (unlike an EMI), you are buying an investment every month (or quarter). There is no question of prosecuting you for missing one investment. As a matter of discipline, you should not miss any payment.

SIP works for everybody, but does not work for me: A psychological myth. SIP works in a well-diversified equity fund in the long run. When people put forth arguments that it does not work for them, they have either not chosen a good fund or are looking at a 12 month horizon.

Now that the common misconceptions about SIP have been clarified, I shall discuss some unique advantages that elevate this mode of payment to the pedestal that it deserves in the subsequent blog.

The Final Call

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

The Final Call

The option you select will be a function of your income requirement (although dividend income is not a guaranteed income), time horizon as well as the tax bracket that you are in. The option of whether to go for an equity fund or debt fund is a function of your risk appetite and asset allocation.

If you want to invest in an equity-oriented fund for less than a year, it is better to go for dividend payout or re-investment option as equity-oriented funds are exempt from dividend distribution tax (DDT). The growth option would be ideal if it is for more than a year since only short-term capital gains are taxed in the case of an equity-oriented fund.

Debt-oriented funds are not so simple, as you have to balance out between the capital gains tax and the dividend distribution tax.

If your total income falls below the minimum taxable limits, the growth option remains the more tax efficient option across horizons, because in the dividend option, you would suffer the incidence of DDT irrespective of your tax status.

If you are a tax payer and plan to hold a debt fund (money market or liquid fund) for less than one year and fall under the 10% or 20% tax slab, then go for the growth option as this will save you from the 28.3% dividend distribution tax, while your capital gains tax will be 11.3% or 22.6%. In case it is not a money market or liquid fund and you fall in the 20% tax bracket, the dividend option will be the best since DDT is only 14.125%. However, if you fall in a higher tax slab of 30%, then it would make more sense to go for the dividend payout or re-investment option, which will save you more on the capital gains tax of 33.9%, even after factoring in the dividend distribution tax of 28.3%(for money market or liquid funds) or 14.125% (for other debt-oriented funds).

As regards the long-term investment in a debt-oriented fund, it would be advisable to go for growth option. This is because the capital gains tax liability on such an investment will be the long-term capital gains tax rate of not more than 10% and you will not shell out the dividend distribution tax of 28.3% (for money market or liquid funds) or 14.125% (for other debt-oriented funds).

You researched your resources…systematically scouted for consistent performers with sound credentials…selected the right funds and the best option that maximizes returns. Now that the mirror on the wall has answered your question, you have your wealth-building winners ready for action….. actual investment. I shall deal with a disciplined approach to investing, that balances both risk and returns and builds wealth, in the forthcoming blog.

Which Option would you opt for?

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Back to the taxing question with a bang – Which Option would you opt for?

Asset allocation is a method by which you decide the percentage of total investments to be made in different asset classes such as equity and debt. So, when the value of your equity fund grows over a period of time, your exposure to that asset class increases. The key to success in equity investing is to book profits periodically, even if you are a long-term investor. Undoubtedly, the growth option can be described as the best as it advocates long term investing. However, investors have had mixed experiences over a period of time. There have been occasions when investors have sold their units only to see the NAV scale greater heights. Or, they may exit in panic when they see the NAV spiral downwards. Therefore, deciding the right time to rebalance, is a challenge for those who opt for the growth option.

The dividend payout option, allows you to book a profit at different levels without having to worry about the right or wrong time to do so. If you are nearing your retirement, have a low investible surplus, or are uncomfortable with volatility, you are better off opting for the dividend option. In doing so, you get to book profit periodically and divert the dividend amount into safer investment avenues. A dividend payout option may also be a good idea in the case of mid-cap funds or theme funds where the bulk of the returns are earned in short periods. But do not rely on the dividends as a source of income, as declaring dividends is completely at the fund's discretion.

Mutual funds can declare dividends only out of realised profits (less unrealised depreciation in the portfolio, if any). Therefore, the advantage of dividend reinvestment option is that, effectively, you would be booking profits and reinvesting it without paying either capital gains tax or STT at the time of investment (assuming the investment is made in an equity-oriented fund). On reinvestment, no entry load is payable and, therefore, there is no additional cost to you. Capital gains taxation on the dividend reinvestment portion arises only if it is sold within a year. Your cost of acquisition is higher than what it was at the time you entered the scheme, thereby, lowering the gains. This lowering of gains also applies to the gains that you made on the units you had purchased initially. This happens because your initial gains were paid out in the form of dividends. Basically, what a dividend re-investment option does is to convert your capital gains into tax-free dividends and then allow the capital gains to generate gains again. It is only when you book profits or exit a scheme that the gains are subject to tax. So, in effect, although you have made gains twice, you end up paying taxes just once. But the point to be noted is that the entire tax-free dividend amount is reinvested on a particular day, which in a way is timing the market. Considering that timing the market is not a strategy that works all the time, re-investment option may not prove effective at all times. The time it takes to receive dividends and redeploy them, can be better spent by keeping the funds invested. Added to this is the dilemma for finding good opportunities to invest in.

It is against this backdrop that I intend to lead you to the option that will enhance your post-tax returns.

Tax Implications

Work your Way up with your Wealth building Winners! (Contd.)

Performance Evaluation of Mutual Funds (contd.)

Tax Implications

What are the tax rates applicable to income from investment in Mutual Funds? What are the tax benefits you get on investing in Mutual Funds? Answers to these questions will aid you in the task of choosing between the various options.

Tax rates on income from Mutual Fund Investment

There are essentially two kinds of incomes that you would earn from Mutual Funds - Dividends and Capital Gains. If you hold on to your mutual fund investment for more than one year, it is considered to be a long-term capital asset and vice versa. Sale of a long-term capital asset attracts long-term capital gains or losses and sale of a short-term capital asset attracts short-term capital gains or losses. Tax treatment differs according to the kind of income and the tenure of investment.

Dividends from Mutual Funds are completely tax-free in your hands. However, there is a distribution tax @28.3% (including surcharge & cess) for Liquid and Money Market Funds (14.025% for other debt-oriented funds) payable by the Mutual Fund directly to the exchequer. So, in effect, you would stand to receive that much lesser dividend. Equity-oriented schemes are exempted from this tax. For this purpose, equity-oriented schemes have been defined as those schemes that have more than 65% of their assets in the form of equity.

Long-term capital gain is completely tax-free in the case of investment in equity-oriented mutual funds. In the case of debt-oriented funds, long-term capital gain attracts tax at 20% with indexation benefit or 10% without indexation benefit, whichever is lower. Indexation is simply using the cost inflation index tables published by the government to increase your investment cost to the extent of inflation. This is good because it reduces the amount of capital gain and the amount you end up paying as tax. NRIs do not have the cost inflation indexation benefit.

In the case of equity-oriented funds, short-term capital gain is taxable at 10%. Since long-term capital gain is tax-free, long-term capital loss will not be available for set off against capital gain. Short-term capital loss will, however, be available for set-off against short-term capital gain. In the case of debt-oriented funds, short-term capital gain is taxed at the tax rate applicable to your total income. In view of the increase in education cess in the current budget, your rate of short-term capital gains tax will climb to 33.9 per cent if you are in the 30 per cent bracket and 23.6 per cent, if you are in the 20 per cent bracket. While long-term capital losses can only be set off against long-term capital gains, short-term capital losses can be set off against, both, short-term capital gains as well as long-term capital gains.

In the case of resident Indians, there will be no tax deducted at source (TDS) on capital gains. However, in the case of non-residents, tax will be deducted at source.

Securities transaction tax of 0.25% is being levied on all redemptions (including switch outs) in equity-oriented mutual funds. There is no securities transaction tax on debt-oriented funds.

Tax benefits on investment in Mutual Funds

The amount invested in Equity Linked Savings Scheme (ELSS) would be eligible for deduction upto a maximum of Rs 100,000.

To avoid capital gains tax, the capital gain, which is not exempt from tax, can be invested in the specified asset (any bond redeemable after 3 years issued by National Highways Authority of India (NHAI) and Rural Electrification Corporation Ltd.) within 6 months of the sale.

There is no wealth tax or gift tax applicable to mutual fund investment.