Focus On Tax Efficiency Of Returns



Hemant Rustagi
Chief Executive Officer, Wiseinvest Advisors 


Having an investment plan in place helps in keeping investments on track during one’s defined time horizon. Unfortunately, not many investors follow this disciplined approach. In fact, investors establish their investment styles and strategies in different ways. On the one hand, there are investors who begin investing with a clear strategy and objectives, on the other hand, there are those who don’t really plan and hence learn the ropes the hard way. However, an important aspect of investment process that is often overlooked by many investors in both the categories is the tax efficiency of returns. 

No wonder, traditional instruments like bank deposits, bonds, debentures and small saving schemes remain the most favoured options for millions of investors in our country, despite offering lower returns as compared to market-linked products offered by mutual funds. Tax inefficiency of returns, that is, interest is taxed at one’s applicable tax rate, for most of these options further makes a dent in what investors get to keep.

In reality, tax efficiency of returns has to be an essential element of one’s investment strategy. In fact, tax efficiency becomes even more important when one invests for the medium to long-term investment goals such as children’s education, buying a house and retirement planning.

One of the ways to improve pre-tax and post-tax returns is to look beyond traditional investment options and invest in tax-efficient options like mutual funds. On the capital gains front, short term capital gains in equity and equity-oriented hybrid funds, i.e. gains on an investment redeemed within 12 months are taxed at a flat rate of 15 per cent. However, long term capital gain, i.e., gain on investments redeemed after 12 months are taxed @ 10 per cent. Similarly, the applicable DDT for these funds is 10 per cent. As regards debt funds, while short term capital gains are taxed at one’s applicable tax rate, long term capital gains, that is, gains on investments redeemed after 36 months are taxed at 20 per cent after indexation. The applicable DDT for dividend option is 25 per cent (29.12 per cent, including surcharge and cess).

It is important to consider these tax rules while selecting option, that is, dividend, growth or dividend re-investment. For investment in equity and equity-oriented funds to achieve long-term goals like children’s education, their marriage and one’s own retirement planning, the obvious choice would be “growth option”. It allows investors to benefit from the power of compounding as well as tax efficiency of returns.

Similarly, in case of debt funds too, the choice of option will depend upon the time horizon. For a time horizon of less than 36 months, it would be prudent to opt for dividend payout or dividend reinvestment, if the applicable tax rate is 30 per cent. However, growth option will be a better bet for investors in tax bracket of up to 20 per cent. Similarly, for an investment with a time horizon of 36 months or more, growth option would be ideal as one derives indexation benefit. 

As is evident, investing with a clearly defined time horizon goes a long way in letting one make the right choices. It is equally important to minimize portfolio turnover to improve tax efficiency of returns. This can be done by avoiding ad hoc decisions based on the market moods. In other words, by assessing the tax consequences before making abrupt changes in the portfolio and resisting the temptation to sell investments for reasons other than poor performance and changes in one’s personal circumstances, the tax burden can be reduced. It also pays to make the right selection of funds and options therein to minimize the need to make changes in the portfolio in the short term. Last, but not the least, by honoring one’s time commitment, haphazard decisions can be avoided. 

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