Over the last few years, tax-oriented planning of investments and redemptions has become much more important. Unfortunately, many investors haven't realised this and are paying unnecessary taxes.
02-May-2023 •Dhirendra Kumar
Investment type A makes your money 14.5 times over 25 years, while investment type B makes it 18.75 times over the same period. It sounds like a no-brainer. Obviously, anyone would choose B. The difference in returns is so large. What if I told you that these two are the exact same investments? There is no difference between them in terms of what the money was invested in. All the difference comes from the tax paid on the gains! In terms of annualised returns, the first case yields 10.8 per cent, while the second one yields 11.9 percent. Accumulated over long periods of time, this builds up to very large differences in returns.
Here's how I arrived at this figure: This was a hypothetical study of the tax impact of churning equity mutual fund holdings versus holding them for long periods of time. Currently, the tax on long-term capital gains from equity-based investments is 10 per cent, with the first Rs 1 lakh of gains being tax-free. To understand the tax impact, let's look back 25 years and imagine an investment that gains at the same rate as the BSE Sensex. For now, let's look at the taxation without taking into account the Rs 1 lakh because the net impact of that depends completely on how much you invest, but more on that later.
In the first case, we have looked at the returns generated by someone who rotates the investment once every two years. By the standards of many investors, this is actually very stable behaviour. In the second case, we have looked at the full returns of someone who buys, then holds, and then sells once. The buy-and-hold investor earns 30 per cent more than the one who churns. Someone looking at the taxation naively would probably think that the tax is just 10 per cent. However, over a portfolio's lifetime, if you buy and sell too often, the impact of the 10 per cent is much, much higher. Every time you pay tax, that money will not earn anything for you in the future. A tax deferment is like a tax rebate in a case like this.
For too long, the tax structure of investments in India was very churn friendly. Once one year of equity investment was over, selling was tax-free. This has created an investment (and advisory!) culture of switching investments at the smallest excuse. For debt funds and other non-equity funds, too, cost indexation created a relatively benign tax structure. However, those days are gone now - nothing is free. In fact, in combination with the change in the taxation structure of non-equity as well, we now have an investment environment where great care has to be taken in planning for the tax impact on returns. Online tools like "My Investments" on Value Research Online can help you do that with ease. Investors should not be flying blind, discovering the tax impact of investments only after the transactions are done.
Note that I'm not saying by any means that you should invest or not invest in a type of investment based on tax efficiency alone. Sure, an investment's tax efficiency only means how effectively it minimises tax liabilities, which can impact your overall returns. While this is an important consideration, it should not be the primary focus when making investment decisions. Rather, the suitability of an investment for your financial goals should take precedence. Your financial goals encompass a variety of factors, including your risk tolerance, time horizon, and specific objectives such as retirement, education funding, or wealth preservation. Ensuring that an investment aligns with these factors is the primary factor in achieving long-term investment success. By focusing primarily on tax efficiency, you are more likely to inadvertently choose investments that are not well-suited to your life. Tax is an important part of the investment story, but by no means is it the major one. This may appear to be a contradiction, but it's not.
Choose investments according to your financial goals, but within the type of investment you have chosen, do not ignore how your actions can impact the taxes you pay on your returns.
Suggested read: Beyond taxation