Execute your investments within your risk appetite, and try to generate higher returns.
Investment decisions should be based on its fundamental aspects and suitability. Having said that, for an investment that is suitable for you, you would look for tax efficiency. This is to enhance net-of-tax returns, which is what you ultimately take home. Given that mutual funds (MFs) are the most popular investment vehicle, let us see how to generate tax efficiencies here.
Systematic withdrawal plan (SWP): This is a method where you redeem a pre-decided amount from your MF investments at a set frequency, usually every month. The purpose is to have a cash flow e.g. in retirement phase. The taxation of MF schemes is such that in the growth plan, your investments become eligible for long term capital gains (LTCG) taxation, after a holding period of one year for equity-oriented funds. For debt or fixed income-oriented funds, the holding period required is three years. For equity funds, LTCG tax rate is 10% (plus surcharge and cess as applicable), that too beyond ₹1 lakh of capital gains per financial year. This tax rate is much lower than the other options that is short term capital gains (STCG); or dividend option (now known as income distribution cum capital withdrawal option) which is your marginal slab rate. The marginal tax rate is usually 30% (plus surcharge and cess) for most investors. For debt funds, the LTCG rate is 20% (plus surcharge and cess) but after the benefit of indexation, which reduces the effective tax rate significantly. The idea is, when you plan to start a SWP, do it in such a way that it starts after one year from your investment in that fund for equity funds and three years for debt funds. If you are investing through multiple instalments e.g. systematic investment plan (SIP), accounting for tax purposes works on first-in-first-out (FIFO) basis, hence you have to ensure that gap from each instalment to withdrawal.
Tax harvesting: For equity funds, in growth option, LTCG taxation works on acquisition NAV to redemption NAV. That is, the tax rate of 10% is applicable on the extent of increase from purchase NAV to sale NAV. As we mentioned earlier, up to ₹1 lakh of LTCG per financial year, in equity stocks and equity MFs, is exempt. Hence, as and when your equity stock prices and equity MF NAVs move up, you can sell and book LTCG up to ₹1 lakh. You should purchase back the same stock or fund, as equity is meant for long term investments. The benefit of doing this rigmarole is that you are creating a higher base or reference point for your ultimate taxation, when you finally sell the share or fund.
To illustrate this, let us say you purchased an equity fund at an NAV of ₹100 two years ago. You will ultimately redeem the fund after 10 years of holding it, at an NAV of ₹200. As of today, the NAV is ₹125. If you redeem it today and buy it back, you are creating a higher base of ₹125 instead of ₹100, when you finally redeem it. To reiterate, in this exercise, you have to limit it to ₹1 lakh per financial year.
Set-off of gains with losses: Debt funds are often compared with bank deposits. In debt MFs, STCG is taxable at your marginal slab rate. Interest on bank deposits is also taxable at your marginal slab rate. If your holding period in a debt MF is less than three years, then apparently there is no taxation advantage over bank deposits. However, potentially, there is scope to generate a bit of tax efficiency here as well. Bank deposits are taxable as interest, as ‘income from other sources’ in your computation and there is no scope. In debt MFs, the STCG can be set off against capital loss, if you have any, which gives you the elbow room. The rule is, short term capital loss can be set-off against both STCG and LTCG, where the definition of short or long term is as per the other asset against which you are setting off. Long term capital loss can be set off only against long term capital gains. You may have capital loss from equity or any other asset class, and losses can be carried forward for eight years.
The objective of optimization of investments is to generate returns without taking too much of risks. Execute your investments within your risk appetite, and try to generate some ‘alpha’ i.e. relatively higher returns, within your parameters.