Tax Efficiency with Mutual Funds

There are many types of taxes that can affect your investments, making it important to understand how they impact your investments


The impact of taxes on your investments, especially in the long run could be significant, yet many investors do not consider the impact until they face it. Income tax savings is not a onetime annual affair; it is about using smart tax savings techniques to reduce your overall tax liability. When investing in mutual funds, there are ways to create a plan that will help you manage, defer as well as reduce taxes.

A widely popular way to use tax savings is to invest in ELSS (Equity Linked Savings Scheme) that qualify for tax deductions under Section 80C of the Income Tax.

But the ambit of taxes when investing in mutual funds involves capital gains and dividends. Capital gain is the profit you make when you sell any investment including mutual funds. For instance, if you invested ₹1 lakh in a mutual fund scheme, which grows to ₹1.25 lakh when you redeem it; you will have ₹25,000 as capital gains. Depending on the type of mutual fund scheme and the duration of holding before redemption; capital gains tax are applicable (See: Tax Impact on investments) under two different buckets, based on the duration in which these were generated — Long term Capital Gains (LTCG) and Short Term capital gains (STCG).

Dividend, which is the gains received when investing in the dividend option of a mutual fund scheme is another way to factor gains from investing in mutual funds. Currently, the dividend income is tax free in the hands of the investor, but the mutual fund scheme pays a dividend distribution tax (DDT). This, rule will change from April 1, 2020 when dividends will be taxed in the hands of the taxpayer according to the tax proposals in Budget 2020. This move makes the dividend option less tax efficient compared to the growth option.


In the case of SWP of ₹1 lakh, the tax liability would be 31.2% (30% slab rate + 4% cess on the tax) on the capital gains. To receive ₹1 lakh through SWP; 9,091 units would need to be sold at ₹11 NAV. The capital gains on the units sold would be ₹9,091 [9,091 units X (₹11 – ₹10)] Tax at 31.2% of ₹9,091 = ₹2,836.

Ideally the choice should be based on one’s cash flow needs and not on the tax treatment. If one is at the highest 30 per cent tax slab, growth option is tax efficient compared to the dividend option, as dividends will attract tax from April 1, 2020. But, there is a way to circumvent the cash flow needed by way of dividends in a tax efficient manner by using the SWP (Systematic Withdrawal Plan) option when investing in mutual funds.investing in mutual funds. An income stream can be created with the SWP in the growth option of a scheme to avoid tax on dividends received. This income stream will be treated as redemption from the fund scheme and subject to capital gains as applicable. The tax treatment depends on the period of holding of the mutual fund units. If SWP is done for a debt mutual fund, the capital gains are taxable both for long and short term.

STCG are taxable if the units have been held for less than 36 months. These are taxed at the income tax slab rates.

In case of long term capital gains (LTCG) on debt mutual funds, they are taxed at 20% with indexation. LTCG of 10% is applicable in equity funds if the gains exceed ₹1 lakh and the holding period is over 12 months. And, the applicable STCG in case of SWP of equity mutual fund is taxed at 15%. The tax efficiency is subject to erosion of capital gains are less and the SWP dips into the capital instead of the gains. the


LTCG of 10% on equity funds is applicable if the gains exceed ₹1 lakh and the holding period is over 12 months.

With tax harvesting strategy, you could book profits up to the ₹1 lakh threshold as it improves tax efficiency over the long term when investing in equity mutual funds. In this method, a portion of your gains are booked as profits and reinvested. Basically, you sell part of your equity mutual fund holdings to book long term capital gains, and then buy back units in the same mutual fund scheme. For instance, if you had invested 1,000 units in an equity mutual fund scheme at NAV of ₹80 on January 1, 2019 and its NAV shot up to ₹130 on January 3, 2020, the long-term capital gains (on holdings above 12 months) will be ₹50,000. If you sell the investments in these units immediately and buy them a few days later, your acquisition price and date will be reset to the new purchase price and date of reacquisition, although the new NAV could be higher or lower than ₹130. For the sake of simplicity, let us assume you bought the units for ₹130 and the NAV goes up to ₹200 after 12 months; your gain will be ₹70,000, which will still be tax free as it will be less than ₹1 lakh threshold. If you had not harvested the gains, your original investment at NAV of ₹80 would have grown by ₹120, or ₹1.2 lakh attracting tax on the ₹20,000 gain at 10 per cent, which you could avoid by harvesting gains each year.

While there are ways to make your investments more tax efficient; you could adopt a technique based on what may work for you. You could use online tools to evaluate the gains applicable on your mutual fund investments before you decide on an action. You should also know that the process of smart tax savings and efficient management of gains requires understanding of how these strategies work, and may need the assistance of experts to calculate the gains on your actual mutual fund holdings.


Disclaimer :

The views and opinions expressed are those of India Today and do not necessarily reflect the views of SBI Mutual Fund. SBI Mutual Fund or any of its officers, employees, personnel, directors make no representation or warranty, express or implied, as to the accuracy, completeness or reliability of the content and hereby disclaim any liability with regard to the same.

The material prepared is for investor education purpose and for general information only. The material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinion provided herein is based on the various parameters/inputs and there is no assurance or guarantee that the investment goals will be achieved. Investors are advised to refer the Scheme Information of the respective Scheme and consult their financial, legal and tax advisers for planning of goals as well as before taking any decision of investment.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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