Equity Mutual Funds remain your best long-term investment tool. Don’t let the LTCG deter you.
In the wake of Arun Jaitley’s announcement that Long Term Capital Gains on equity would be taxed, the stock markets reacted sharply. Small investors, who had begun to trust financial assets over real estate and gold, gave the move a thumbs-down. Long Term Capital Gains on equity – basically, investments held for a tenure of 365 days or more – were exempt from tax. This made equity Mutual Funds extremely attractive, especially in the post-demonetisation phase when many funds returned 30-50% returns in a year. Now, post January 31, 2018, LTCG above Rs. 1 lakh on equity investments (shares and Mutual Funds alike) will be taxed at 10% without indexation benefit. This begs the question: is equity still your best bet? Let’s take a deeper look.
Equity MFs Still Your Best
Despite the LTCG, and despite the frenzied selling that followed today, equity Mutual Funds still remain your best bet for long-term wealth building. Even accounting for a 10% tax on your long-term gains, equity investing have the potential to outperform returns from most other savings and investment schemes. As per the CRISIL AMFI Equity Fund Performance Index for December 2017, equity funds had a CAGR of 35.59% in one year, 13.08% in three years, 17.64% in five years, and 8.94% in 10 years. Therefore, the LTCG is at best something that sours the investor sentiment. It’s certainly not a deterrent to investment.
Your Gains Need To Be More Than Rs. 1 Lakh First
The LTCG tax is unlikely to impact small investors who invest via SIPs for the short or mid-term. Let’s say on April 1, 2018, you started a monthly SIP for Rs. 5000 for five years, earning a moderate CAGR of 10%. By March 31, 2023, five years later, your invested corpus of Rs. 3,00,000 grew to Rs. 3,90,412. For the purpose of an LTCG calculation, let’s say you liquidated the entire investment after all its units qualified for LTCG Tax, i.e, on April 2, 2024. Let’s assume the fund grew 10% more in that period, to Rs. 437,261. Your total LTCG here is (437261-300000) = Rs. 137261. Of this, Rs. 1,00,000 is exempted from LTCG Tax. On the remaining – Rs. 37,261 – you’ll pay Rs. 3,726 as tax. Therefore, not only would it take the average small investor several years to create LTCG of more than Rs. 1 Lakh, he would also pay a small tax only on the non-exempted gains.
How Taxation Compares
Let’s imagine you had invested the same amount over five years in a 7% Recurring Deposit with your bank. Let’s also assume you’re in the 30% tax slab. Your effective rate of return on the investment is 4.9%. Assuming you’ve availed your interest exemption of Rs. 10,000, this investment will yield you just Rs. 340,549 – well behind the projected corpus from your Mutual Fund investment above. The same investment in PPF, which is a completely tax-exempt scheme and currently returns 7.6% per annum, will provide you a corpus of around Rs. 3.7 Lakh.
You Can Smartly Reduce Tax Liability
There are many ways to remain under the Rs. 1 Lakh limit and lower your tax incidence. For example, you could invest in your spouse or child’s name and ensure the projected gains remain less than Rs. 1 Lakh during redemption. You could also redeem less than Rs. 1,00,000 per redemption per family member, thus remaining under the exemption limit.
Exiting Now? Check Exit Load & STCG
If you’ve decided to exit your Mutual Funds for any reason, consider three costs. One – the exit load. Every Equity Fund imposes a levy when you redeem your units within a stipulated period. For example, many funds charge 1% for redemption within 365 days of investment. Two – check your expense ratio. This would reduce your absolute returns. Three – check the investment tenure. You pay 15% tax on Short Term Capital Gains on equity investments, whose tenure is less than 365 days. Instead of paying a little extra towards your exit load five percent more towards STCG, you can wait a little longer and reduce these costs.
India’s Growth Story
The Indian markets continue to have great long-term prospects with projected economic growth pegged at 7-8% per annum. If you’re an investor looking for long-term returns, you should not pull out and remain invested. If you’re a Mutual Fund investor, you’re still using the best savings instrument there is and will continue to earn long-term returns better than most asset classes. The introduction of the LTCG should not change your long-term outlook.