I have got a lot of queries for sharing my strategy of creating a passive income stream to take care of my regular expenses. This helps me in having peace of mind and allows me to take up the kind of work that I am genuinely interested in. I have multiple strategies to take care of the passive income stream as well as backups for some of these. One of them is my investment in tax free bonds which gives me about 1/3 of my annual expenditure need. The other strategy was to invest in FMP s in a way that I generate income out of it. I will explain how I do so in this post.
As many of you know, a Fixed Maturity Plan is really a category of Debt mutual fund where the redemption date is defined. All FMP invest in government papers and other such highly secure instruments which will mature on or just prior to the date of the FMP maturity. Therefore, in essence you can be assured that your returns will only fluctuate within a very narrow range even though the fund houses cannot tell you that due to the SEBI guidelines. What attracted me to FMP in the first place was the fact that the returns were pretty much comparable to an FD and sometimes even better but the FMP had a huge tax advantage. Having paid huge taxes in my years of corporate earning, I was especially keen to see that I can minimize my tax outgo when I was setting up a passive income stream.
Till the budget of July 2014, FMP really was a great product as the LTCG for it was defined at 1 year. Essentially, this meant if you could earn 8-9 % in a year, indexation took care of most of it and your tax liability was practically minimal or even nil. From 2010 through 2014 this was a bonanza as far as I was concerned. I could use the capital gain to fund some discretionary expenses and indulgences, not really pay much taxes on it at all and roll over the principal. To give an example an FMP of 3 lacs for 1 year will have a capital gain of about 24000 Rs which can be used for any purpose and the principal of 3 lacs could be rolled over into another FMP.
The tax treatment of FMP was really an anomaly and it got corrected in the 2014 budget where the LTCG was defined at 3 years. Fortunately, the option of rolling over 1 year FMP to 3 year FMP was given by most fund houses, so in effect the deal was not really a bad one. It did mean that the capital gains I was expecting in 2015 from the 1 year FMP would not happen in the year. This was not an insurmountable issue as I had several backups for the passive income needed.
Let me show you a generic example of how FMP can be configured to generate a passive income stream:-
- Let us say you have put an amount of 30 lacs in FMP, with 10 lacs maturing every year. This is what I had done in 2013 and 2014 when I wanted to create a passive income stream from 2015.
- Each year 10 lacs of FMP will be maturing and all of these will be 3 year FMP. You will therefore be getting a total amount of around 12.7 lacs ( assuming 9 % return ). 2.7 lacs out of this is LTCG and after indexation benefits you will not pay much taxes on it. So in effect you have this amount tax free ( nearly ) for your passive income.
- You invest the 10 lacs principal amount into other 3 year FMP or other debt funds as per your choice.
- You will continue to get this year after year and the tax incidence is limited, definitely nowhere near FD s.
Having said all this, do FMP s remain as attractive now as it used to be a couple of years back? One issue clearly is that like other Debt funds you need to have these for 3 years now in order to get indexation benefits. That is OK but there are issues in indexation as well as the returns that we need to consider. Let me do another post on this as this one is already quite long now.