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When SIPs make no sense, nor do dividend plans

There are some situations when SIPs are pointless, unlike dividend plans which are always pointless

When SIPs make no sense, nor do dividend plans

A few days back, I received an email from an old retired person that began with the rather alarming statement, 'Kindly do not take my words as criticism but I feel that your opinion regarding SIP is biased.'

It's always distressing to see savers come up with reasons for not investing through SIPs but this email was different. This retiree really had come up with one of the few situations where investing through SIPs in an equity fund doesn't really confer any additional advantage over a one-shot lumpsum investment.

I'll discuss that in a moment, but this investor made another point in his email in which he was quite mistaken, and was in fact suffering from a common misconception. He complained that I had advised against dividend options of funds. However, he needed a regular monthly income, so how could the growth option be suitable for someone like him?

This dividend delusion is a very common one and arises because mutual fund dividends are not dividends at all. To the investor, the word dividend brings to mind corporate dividends, which are indicative of how profitable a company is and how much of the profits are being distributed to shareholders.

In mutual funds, this is NOT the meaning of the word 'dividend'. Instead, they are just a withdrawal from your money. If the value of your investment in a mutual fund is Rs 1 lakh, and then the fund gives you Rs 5,000 dividend, the value of that investment will be reduced to Rs 95,000. In equity funds, there was no tax on these dividends till last year. But now, even in an equity fund, there's a 11.648% tax on dividends paid after that date. So including surcharges and cess, you will get Rs 4,418 as dividend while your investment goes down by Rs 5,000.

However, if you were to just withdraw (redeem) the same amount, then the tax would be lower or may even be zero. The reason is that in case of redemptions too, the tax rate is 10 percent plus surcharge, chargeable only on the gains part and not the entire amount. Even on the gains, up to Rs 1 lakh of gains are exempt every year. No matter how, the tax is going to be always lower than the dividend option. Thus, it never makes sense to opt for a dividend plan.

Instead, someone needing a regular income should just redeem the amount every month, either manually or by starting a Systematic Withdrawal Plan (SWP). You'll pay less tax and for the same amount in hand, you will eventually make more money because you will withdraw less and thus the money will earn more.

The logical question that you would now ask is why do dividend plans exist at all? The simple answer is that they should not. Once upon a time, there was some advantage to them but now they serve no purpose except to reduce the wealth and income of old retirees like this person who wrote to me. SEBI should force mutual funds to convert them to equivalent SWP plans.

Now we come to the SIP issue. This retiree basically cycles money in and out of ELSS plans every three years in order to save tax. He invests in ELSS funds and after the three year lock-in is over, he withdraws the money and invests it again to gain the tax break. He feels that SIP is pointless for this and he is absolutely correct. SIP is needed when one moves money from a non-equity situation (like your bank account or a deposit) into an equity fund. This protects investors from catching a market high and losing money.

If the money is already in an equity fund and you are just redeeming and reinvesting it, then SIP is not needed, this being one of those rare situations where that is true.