The money you invested is what you had after paying taxes, and the gains you make on this investment are taxed again. There was a time when long-term capital gains were tax-free in India.
Now, an investor must pay short-term capital gains (STCG) or long-term capital gains (LTCG), depending on the holding period.
While the short-term capital gains tax is necessary to reduce speculation, the long-term capital gains tax undermines the purpose of financial planning.
Let us analyse the problem and its solution in detail today.
Capital gains taxes were introduced in 2018 and have hindered every financial advisor who provides capital planning/appreciation to their investors, i.e., the ability to switch funds when the goal has been met.
You may recall that goal setting was a crucial step before actually investing. Similarly, switching funds to a safer asset as the tenure ends is equally important. In the new tax rule, switching funds solely for protection will not yield the desired results.
Let us illustrate with an example.
You had a financial goal of raising Rs 24 lakh at the end of 10 years to fund your child’s higher education. Assuming you invested a total of Rs 12 lakh and the markets were very generous, and your fund value rose to Rs 33.63 lakh at the end of the 9th year.
The investment advisor/mutual fund distributor would help you with three options:
1. Withdraw the entire amount and move to cash.
2. Stay Invested in the Equity Fund.
3. Switch from Equity Fund to Debt Fund.
1. Withdraw the entire amount and move to cash
If you withdraw the funds now, you will pay approximately Rs 2.54 lakh in taxes, and your final amount would be 33.63-2.54 = Rs 31.09 lakh. Tax is calculated on the gains, i.e., 12.5 per cent of (33.63-12-1.25 lakh) = Rs 2.54 lakh. (Rs 1.25 lakh is the LTCG exemption limit per year. 12 lakh is the original capital. STT, stamp duty, surcharge & cess are assumed to be nil.)
Once you withdraw this amount, your funds will remain as cash and will not generate interest income or capital gain. If the markets move up 10 per cent the following year, your opportunity cost will be Rs 3.1 lakh.
2. Stay Invested in the Equity Fund
If the markets remained positive, the investor would have achieved a higher fund balance. However, if the markets crashed by 20 per cent in the 10th year, the fund value would have dropped to Rs 26.9 lakh (33.63-20 per cent). The capital gain would be 26.9-12 = Rs 14.9 lakh, reducing the LTCG exemption of Rs 1.25 lakh; the next taxable amount would be Rs 13.65 lakh.
Final taxes at 12.5 per cent would be 13.65 x 12.5 per cent = Rs 1.706 lakh. The investor would have received 26.9-1.706 = Rs 25.194 lakh. (STT, stamp duty, surcharge & cess are assumed to be nil.)
3. Switch from Equity Fund to Debt Fund
If the investor switches from an equity fund to a debt fund at the end of year 9, the calculations will be as follows, assuming the debt fund returns 7 per cent.
Amount Invested = Rs 31.09 lakh
Yield = 7 per cent
Fund Value = Rs 31.09 lakh + 7 per cent = Rs 33.26 lakh
Gain = Rs 33.26-31.09 lakh = Rs 2.17 lakh
Debt fund taxation (assuming the highest income tax slab) 30 per cent = Rs 2.17 lakh x 30 per cent = Rs 65,100.
Final value received by customer = Rs 33.26-0.651 lakh = Rs 32.60 lakh
(STT, stamp duty, surcharge & cess are assumed to be nil.)
A smart switch from the equity fund to the debt fund helped the investor realise Rs 32.6 lakh instead of Rs 25.19 lakh, at a time when the stock markets crashed.
If not for LTCG, the investment advisor/distributor would have switched from equity to debt at the end of the 9th year, as capital protection for their client would have been their top priority. Now, they have to make one of these three choices and face their consequences.
There is a category of mutual funds that addresses this problem: Dynamic Asset Allocation Funds (DAAFs). It can go from “100 per cent Equity and 0 per cent Debt” to “0 per cent Equity and 100 per cent Debt” with ease. The investor can rely on this professional manager to make adjustments based on market conditions.
A few AMCs are offering a DAAF as a FoF (Fund of Funds). The most striking advantage is a 12.5 per cent tax benefit if the tenure exceeds 2 years, even at 100 per cent debt allocation.
Normally, a 100 per cent debt fund is taxed at 30 per cent (assuming the highest income tax slab), but a FoF can evade this. Let me illustrate with the same example as above.
If the investor had invested in a DAAF FoF with a 100 per cent equity allocation through the 9th year. The fund manager switched from 100 per cent equity to 100 per cent debt in the 10th year, assuming the markets would crash. If his assumptions turned true and the markets crashed, he would have helped his investor in three ways.
1. The wealth is protected as it was moved from the risky equity class to the low-risk debt class.
2. Since the switch was made by the Mutual Fund manager, not by the client, there is no tax liability for the investor in the 9th year.
3. The tax rate for a full redemption in the 10th year will be only 12.5 per cent for this FoF. This ensures the after-tax retirement corpus is much higher than any other method.
The writer is a SEBI Registered Investment Adviser (RIA), INA000021757, and author of ‘How to join the top 1% options traders club’.
The opinions expressed in this article are those of the author and do not purport to reflect the opinions or views of THE WEEK.
