Revealed — Why Mutual Funds remain the best investments despite LTCG tax?
Apart from consistently outperforming the markets, Equity Mutual Fundshave also enjoyed zero tax if held for more than 1 year. The Union Budget 2018 is set to change that with 10% Long Term Capital Gains Tax on gains above ₹1,00,000. Does this LTCG Tax take the sheen out of mutual funds for long term investments? The answer is NO.
Equity investing has outperformed most other savings and investment schemes. Even after accounting for 10% LTCG tax, they remain the highest return investment class. Let’s look at the impact of new LTCG tax on performance of equity mutual funds:
This means that an investment of ₹5 lakh made 3 years ago would give post LTCG tax annualized returns of 12.44% as compared to 13.08% before Budget 2018. You can also see that returns on investment of ₹1 lakh made 3 years ago are not at all impacted by LTCG tax!
As is clear from above, equity mutual funds generate high returns even after imposition of LTCG Tax. Given that gains up to ₹1 lakh are exempt, the actual LTCG tax % can turn out to be much lower than 10%, even 0 if planned properly.
The following process diagrams help you understand how the new tax regime works.
Equity Mutual Funds purchased on or before January 31, 2018
All long-term gains until Jan 31, 2018 are tax exempt. If you have invested before Jan 31, 2018, tax will depend upon your investment horizon and selling date. Refer to the chart below for more information.
Equity Mutual Funds purchased on or after February 1, 2018
If you have invested on or after Feb 1, 2018, tax will depend on your investment horizon. Short term capital gains will be tax at 15% and LTCG greater than Rs. 1 lakh will be taxed at 10%.
LTCG tax has minimal impact on small investors
LTCG tax is unlikely to impact small investors who invest via SIP for the short or medium term. Let’s assume you invest Rs. 5 lakhs for 2 years in an equity mutual fund. If your investment generates a CAGR of 15% for the period, your investment would have grown to Rs. 6.6 lakhs. Your total LTCG here is (6.6–5) = Rs. 1.6 lakhs. Of this Rs. 1 lakh is tax exempt. Only the remaining Rs. 60,000 will be taxed at 10% and you will have to pay Rs. 6,000. Hence, the effective tax rate is (6,000/1.6 lakh) = 3.75% of your LTCG. To sum it up, an average small investor would end up paying a small tax only on non-exempted gains. In the light of superior returns generated over last 25 years, equity funds are a much better asset class.
Post LTCG Tax Comparison
Let’s imagine you had invested the same amount in FD, PPF, ULIP and mutual funds over 2 years. The highest return Fixed Deposit (FD) earn only 7%. Let us also assume you are in the 30 per cent tax slab. Your effective rate of return on the this FD becomes 4.9%. The same investment in PPF, which is completely tax exempt and currently returns 7.6% albeit with a 15 years lock-in. Unit linked Insurance Plan (ULIP) generally returns around 7% with a 5 year lock-in period. Let’s compare the ending value of the investment under each case:
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Since Rs 1 lakh of LTCG is tax exempt, you could sell investments that would generate that much returns every year. Let’s look at an example.
Let’s assume you invested Rs 10 lakh in an equity mutual fund on Feb 1, 2018. If your investment generates a return of 15% over 1 year, it would have grown to Rs. 11.5 lakhs. This implies an LTCG of (11.5–10) = Rs 1.5 lakh. You could sell investments that have generated 1 lakh of LTCG so that it is tax exempt. Since Rs 10 lakh has generated Rs 1.5 lakh, you could sell exactly 67% of your NAV units to generate LTCG of Rs 1 lakh.
From this discussion we can clearly see that equity mutual funds are the best option for long term investments in the new tax regime. They give you better post-tax returns and the impact of LTCG tax is minimal on small investors.
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