Some ideas to make your mutual fund investments tax-efficient

By following a few simple steps to reduce the tax impact, investors can gain more out of mutual fund investments

In our article dated February 10, 2020(Budget aftermath: reap the dividends, don’t fret) we discussed that the growth option of mutual fund (MF) schemes is more tax efficient than the dividend option, more so after the Union Budget presented on February 1. Let’s discuss this in detail.

There are two types of funds from the tax perspective — equity and debt. Hybrid funds are classified either as equity or debt in this respect. If a fund has more than 65% in equities, it is classified as an equity fund and more than 65% in debt makes it a debt fund for tax purposes.

Let’s start with equity funds. In equity funds, growth option becomes long term from the tax perspective after a holding period of one year. The taxation rule says, on your gains from the growth option, you pay tax at 10% plus surcharge and cess as applicable on gains of more than ₹1 lakh per financial year. In other words, up to ₹1 lakh of long-term capital gains per year is free from tax; beyond that you pay 10% plus surcharge and cess on your gains.

Tax efficiency

There is a method of generating further tax efficiency within this rule. Even if you do not want to move out from an equity stock/equity MF, and if the price/NAV has moved up since your purchase, you can sell (i.e. book the gains) and repurchase the same share/MF Scheme.

How does it help? It helps by creating a higher acquisition cost for tax purposes when you finally exit the stock/scheme. For taxation of equity, January 31, 2018 is known as the ‘grandfathering date’ i.e. prices /NAVs prior to this date is to be ignored and this becomes the cost of acquisition for all future dates. Let’s say the price/NAV as on January 31, 2018 was ₹100 and you would eventually sell it after seven years when the price would be say ₹170. At that point of time, you would pay tax on ₹170 minus ₹100 = ₹70, provided the gain is more than ₹1 lakh in that financial year and tax laws remain same as on today. Currently, two years have passed from January 31, 2018 and price/NAV has moved up to say ₹120 as on February 2020.

Today, if you sell the share / MF scheme at ₹120 and purchase it again, as long as the gains e.g. ₹120 minus ₹100 = ₹20 is within ₹1 lakh, it is tax free for you. How it helps you is, through this transaction, your cost of acquisition moves from ₹100 to ₹120, which will be relevant when you eventually sell it after another five years at ₹170. At that point of time, your gains will be ₹170 minus ₹120 = ₹50 instead of ₹170 minus ₹100 = ₹70.

To give another perspective to the same idea, let’s say you invested ₹10 lakh in equity MFs at an earlier date (more than one year ago) and the portfolio value as of today is say ₹10,99,000. You can redeem the entire portfolio as the gains are within ₹1 lakh in the financial year.

Higher acquisition cost

Since equity investments are long term, you invest again in the same funds and create a higher acquisition cost. If the market value of the portfolio today is say ₹11,50,000, then for executing this strategy, you have to sell as much as your gains are within ₹1 lakh in the financial year, to avoid paying tax. In the dividend option of MF Schemes, as and when the Union Budget proposals are passed and becomes applicable from April 1, 2020, you have to pay tax on dividends at your marginal slab rate, which for most investors is 30% plus surcharge and cess. In the growth option, as long as you hold it for one year and it becomes long term for tax purposes, you either pay tax at 10% or if the gains are less than ₹1 lakh, it becomes free of tax.

Now, let’s discuss the final piece on taxation of your equity MF investments. The illustrations above assume that you invested in the fund lump sum i.e. on a particular date and exited lump sum on a particular date. In reality, you may invest in a fund over multiple dates e.g. through a Systematic Investment Plan (SIP) and may withdraw over multiple dates e.g. through a Systematic Withdrawal Plan (SWP). In such a scenario, to match against the exit, the NAV of your earliest investment in the fund will be taken.

The jargon for this is First- In-First-Out (FIFO). As an example, if you did a SIP in a fund from January 1, 2018 to January 1, 2019 and exit today, the acquisition NAV as on January 1, 2018 will be relevant for tax purposes i.e. today’s NAV minus that on January 1, 2018 is your gain. If you do an SWP from January 1, 2020 onwards, the first i.e. earliest investment will be considered for taxation, for every exit.

(The author is founder, wiseinvestor.in)