Why The LTCG Tax Is No Big Deal

Contrary to popular perception, despite the newly-introduced LTCG tax, Mutual Funds remain one of the best investment avenues available today. #ltcg #budget2018 #mutualfunds #investments

Why The LTCG Tax Is No Big Deal

Every day there’s a column in every other newspaper about the Long Term Capital Gains (LTCG) tax introduced by the government in the Union Budget this year. Equity Mutual Funds, including the most popular Equity Linked Savings Schemes (ELSS) that provide tax benefits, will be taxed at 10% from April 1, 2018. The effective tax rate will be 10.4% if you include the education cess. Will this put a big dent in your returns from equity Mutual Funds? Actually, no! Equity Mutual Funds can still give you much higher returns than those from the Public Provident Fund (PPF) and Unit Linked Insurance Plans (ULIPs). How?

Look at the numbers

The return that you get from PPF is 7.6% per year and ULIPs hardly give you 8%-9%, considering all those charges that you have to pay. Coming to Mutual Funds, let’s take a conservative return of 12% for your Mutual Fund investments. Since returns from PPF and ULIPs are tax-free, you will get 7.6% and 9% from them, respectively. After you deduct the LTCG tax, you will still get 10.75% from Mutual Fund investments, which is much higher than returns from the other two.

Want some more numbers? Then, let’s take the investment amount. You invest Rs. 1,00,000 in Mutual Funds. Now, what percentage should be taken as an average return from equity Mutual Funds? On the BankBazaar website, among all the funds, let’s take the 5-year return of the worst-performing fund. This will be 15.92%. Now, at this rate of return, your Rs. 1,00,000 will become Rs. 1,15,920. Total taxable gains will be Rs. 15,920, the tax will come to Rs. 1,655 and your post-tax amount will be Rs. 14,265. Your post-tax return will be 14.27% (still good!).

Additional Reading: How International Mutual Funds Are Taxed

Bigger amount, bigger hit?

What if this Rs. 1,00,000 is Rs. 10 lakhs. In that case, your return will be Rs. 1,59,200, your tax will come to Rs. 16,556 and your post-tax amount will be Rs. 1,42,643. Only in value terms, there’s a bigger hit. Your post-tax return will still be 14.26%. So, equity Mutual Funds could give you much better returns than all those investments out there even if you have to pay tax on the gains.

Why ULIPs may not be great

There is a big hue and cry about how ULIPs can give you better returns than equity Mutual Funds. Actually, there are plenty of reasons why ULIPs might not be such a great idea. Number one is that ULIPs come with a big lock-in period (read 5 or more years). Equity Mutual Funds can be withdrawn at any time. Even if you invest in ELSS Mutual Funds, the lock-in is just 3 years.

Next important point is the cost of purchasing ULIPS. There are charges that you might have to pay when you invest in ULIPs. This will include premium allocation charges, mortality charges, and fund management charges. The charges could be as much as 4% of your investments. Usually, equity Mutual Funds come with an entry load of just 2% or less. There are even funds that don’t charge an entry fee. This is precisely why investing in equity Mutual Funds might be more cost-effective when compared to ULIPs.

Additional Reading: Mutual Funds Taxation Post Budget: All You Need To Know

The same is the case with exit fees. If you hold the equity Mutual Funds for more than a year, then, there is usually no exit fee.  In case of ULIPs, there is a restriction on premature withdrawal. Even after the lock-in period is over, there might be charges to withdraw from your ULIP.

What happens when the investment underperforms? For ULIPs, all you can do is shift from one fund to another under the same insurer. In case your equity Mutual Fund underperforms and you don’t like the fund house, you can withdraw your money and invest in another fund from another fund house. And if you didn’t already know, ULIPs will be taxed if your premium is more than 10% of the sum assured.

So, it might not make sense to go for ULIPs just because the returns are tax-free. If the returns don’t even beat inflation, then what’s the whole point of having returns that are tax-free? You might as well pay tax and get better returns elsewhere. That’s why you need to weigh the pros and cons of any investment, always.

This article was originally published on LinkedIn.

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Category: Capital Gains Taxes ExpertSpeak

About Rati Shetty - Founder & CPO, BankBazaar.com

Sugar and spice and everything nice, Rati certainly imbibed some rich qualities from Toblerone in Brazil and Milka in the US while managing the launch and go-to market operations of many of Kraft Food's brands in export markets across the world while working for Kraft in the US and Taiwan. She continues to spread the goodness, raising the bar high for awesome customer experience on BankBazaar.com with astounding outside-the-box ideas for creating beautiful new products, features and applications and ensuring that the end results are perfect, dummy proof and can only lead to one thing: pure customer delight.

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