Mar 30, 2009

Mutual Funds - Tax Benefits

Tax-efficient investment means to minimize the tax-outgo on the returns generated from the investment. The lower taxes results in better yields.

Everybody knows that mutual fund investments are inherently tax-efficient. But did you know that some mutual funds are more “tax-efficient” than other funds and that by taking advantage of this you can minimize your taxes on investments.

So, what exactly are those special tax benefits which makes some mutual funds more tax-efficient than others? Or, how some mutual funds score over others in terms of tax benefits?

Broadly speaking, from taxation angle, there are only two types of mutual fund schemes. Funds which invest more than 65% of their corpus in Indian equities are called equity oriented mutual funds and the other mutual fund schemes which invest in less than 65% in Indian equities are called non-equity funds or debt-oriented funds. Within equity oriented mutual funds there is a special class of equity funds called equity linked saving schemes (ELSS).


Mutual Funds Tax Benefits

1. Debt Funds are better than Investing in FDs [Debt Funds vs FDs]
If you don’t have taxable income, you are better off with fixed deposits (FDs). Else, debt funds provide better post tax returns. Why?

Interest from FDs (Fixed Deposits) is chargeable to tax at the maximum marginal tax rate applicable to you. For example, let’s say a one year bank FD provides an interest @ 10 per cent per annum (p.a.) and your marginal income falls either in 30.90% or 33.99% tax bracket. So your post tax return from fixed deposit becomes 6.91% and 6.60% respectively.

As opposed to this, let’s say you invest in short term debt fund (dividend option) which also earns 10% annualized returns and distribute it among the unit-holders in the form of dividends. That dividend income will be tax-free in your hands but the mutual fund will be paying a dividend distribution tax of 14.1625% (which is indirectly borne by you), so you’ll be getting a net effective return of 8.58% p.a. which is a lot higher than the post tax returns from FDs (assuming same pre-tax returns).

However, if you invest in a debt fund with growth option, then the tax treatment becomes slightly different. For example, let’s assume you invest in an Income or a Bond Fund for two years. Appreciation in the NAV of a debt fund is treated as capital gains. Now, at the time of redemption, returns from debt funds are taxed as Long Term Capital Gains (LTCG) if invested for more than a year. Now, based on the option you choose, LTCG is either taxed @ 11.33% without indexation or 22.66% with indexation. Both the options are certainly better than the tax treatment of FDs where you pay tax at tax slab applicable to your marginal income as already discussed above.

Furthermore, just by investing for a little over 12 months (say 13 or 14 months) in debt funds at the end of the financial year, you can reap double indexation benefits thereby further reducing your tax liability. For example, if you’ve invested in any debt fund during the current month (i.e., March 2009) and you redeem the investment in April 2010, you’ll get entitled for double indexation benefit while calculating your capital gains from the debt funds. This is one of the reasons why mutual funds houses used to launch so many FMPs (Fixed Maturity Plans) during the end of the financial year.

Put simply, for similar pre-tax returns, debt funds provide better post tax returns as compared to FDs. Moreover, no TDS is deducted by mutual funds in case of resident individuals.


2. Arbitrage Funds are better than Debt Funds [Arbitrage Funds vs Debt Funds]
Arbitrage funds take advantage of mispricing for the same asset (equity) in different markets (cash and derivatives). These funds seek to capitalize on the price differences in cash and future segments of the stock-markets.

For taxation purposes, arbitrage funds are treated as equity funds. While enjoying the tax status available to equity funds, arbitrage funds deliver almost assured returns of debt schemes. Put simply, arbitrage funds have edge over debt funds because of the tax benefits.


3. Equity-oriented balanced funds are better than debt-oriented balanced funds
Balanced funds are a better way of asset allocation rather than doing the asset allocation yourself by separately investing in equity & debt funds. You get the benefit of automatic reallocation and therefore avoid the hassle of doing it yourself and further avoid bearing associated costs and tax consequences.

However, from the tax angle, balanced funds having more than 65% in equity are better than those having equity allocation less than 65% because in the former case they are treated like equity funds for tax purposes and get concessional tax treatment / tax benefits applicable to equity funds.


4. Equity Funds are better than Debt Funds [Equity Funds vs Debt Funds]
In case of equity-oriented mutual funds (more than 65% in equity) the LTCG (long-term capital gain) is nil and STCG (short-term capital gain) are taxed at concessional rate of 15% (plus surcharge and education cess).

In contrast, for non-equity oriented funds (i.e. debt funds), while LTCGs are taxed at 10% without indexation or 20% with indexation (plus surcharge & education cess), the STCGs are taxed at highest slab rate applicable to you.

Equity funds also score over debt funds as far as dividends are concerned. Dividends declared by all types of mutual funds (whether equity or debt-oriented) are exempt (i.e. tax free) in the hands of investors. However, a dividend distribution tax (DDT) is to be paid by debt oriented mutual funds which is indirectly borne by the investor / unit-holder. On the other hand, Equity oriented funds (i.e., funds with more than 65% in equity) are exempt from paying even DDT.


5. ELSS are better than plain vanilla Equity Funds [ELSS vs Other Equity Funds]
Among the equity funds, Equity Linked Saving Scheme (ELSS) is the best option. These tax saving funds are like other diversified equity funds but with additional tax advantage of section 80C deduction. It is not without any reason that ELSS is considered as best option under section 80C.


6. Gold ETFs are better than investing in Gold [Gold ETFs vs Gold]
Tax benefits are one of the reasons why Gold ETFs are considered as best way to invest in gold.

For the purpose of calculating long term capital gains, holding period of gold ETFs is one year as against 3 year holding period in case of physical Gold. Furthermore, as against Gold, Gold ETF’s are not considered as an asset for wealth tax purposes.


Thus, while investing in mutual funds, always keep in mind the tax advantages of different kinds of mutual funds so as to optimize your post tax returns from mutual fund investments.



Also see:

1. Home Loan Tax Benefits
2. Direct Stock Investing vs Mutual Funds
3. 6 Myths about Mutual Fund Investing
4. 10 Principles of Mutual Fund Investing
5. Income Tax Calculator

4 comments:

  1. Gautam JainMarch 27, 2010

    Super! Thanks.

    ReplyDelete
  2. Sir,
    I shall be grateful if a model calculation is displayed.
    For instance, I purchase 1000 units of a Debt MF on 1/5/2010 @ Rs.10.361, the total investment being Rs.10361/-. I redeem it on 1/6/2011. With dividends reinvested, the balance of units on the date of redemption is 1250 and the NAV is Rs.10.366 and the redemption amount is 12980/-. What will be my capital gains? Should I take the originally purchased units of 1000 and multiply it @ Rs.10.366, the NAV on the date of redemption or should I take the redemption value?

    ReplyDelete
  3. @#$%#$*@,

    Good question!

    First, I’m changing the dates: 1/5/2010 to 1/5/2009 and 1/6/2011 to 1/6/2010…it is done because the cost inflation index for FY 2011-12 will be available only after six months.

    Now let me answer your question: On the original units of debt mutual fund purchased by you, there is a long term capital loss (since held for more than one year) of Rs. 1,290 calculated as follows:
    Redemption Amount (1000 units @ Rs 10.366) -------------- = 10,366
    Less:Indexedcost of purchase(1000@10.361=10,361*711/632)- = 11,656

    On the remaining 250 units, which you received on reinvestment of dividends, the capital gains will depend upon the date(s) of reinvestment (for deciding whether STCG or LTCG), and the amount of dividend reinvested (for calculating the exact amount of capital gains).

    ReplyDelete
  4. Hi Most of the balanced funds have the range of allocation. Example 40 to 75 in equity and 25 to 60 in debt. So, what is the tax implication for such funds. At some point of time, the equity allocation may be higher than 65, while at other time, it may be lower also?

    Please clarify.

    Thnaks,
    Ashish

    ReplyDelete

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