The single most important point to be noted is that it’s far more beneficial, from a tax point of view, to invest in mutual funds than stocks. While this has been true since February 2018, the hike in long-term capital gains tax in this year’s Budget has made it that much more important. In any case, even earlier, many investors did not appreciate this about taxation.
I’ll recap the underlying principle. All equity portfolios need some buying or selling as individual stocks become more or less desirable. This is true even if you are good at choosing stocks and holding most of these for several years. Time goes by, circumstances change, companies and markets evolve, and the formerly good stocks have to be sold and something better bought. If you are investing in stocks yourself, these transactions will translate into tax liability.
However, in an equity mutual fund, the fund manager does the equivalent trading within the fund. You don’t have a tax liability because you haven’t conducted any transaction yourself. Moreover, this is not just about the tax amount. Over time, the bigger impact is from the growth of this amount. You might hypothetically pay a couple of lakhs of long-term capital gains tax this year, but if you did not have to do it, then five years down the line, this amount could grow to Rs.5 lakh. This is a further multiplier to the tax saved because the money remains available as an investment and gains even more. For long-term investments that compound over years, this can make a huge difference. Obviously, for compounding to happen, you need to be invested in an asset type that does not require you to buy and sell yourself too frequently. This asset type is essentially a diversified equity fund. I refer to a diversified fund because sectoral, thematic and other specialised funds are likely to require adjustment of holding more often, while diversified funds do not.
Another situation where you might need to buy and sell investments is for asset rebalancing. At some point, you might want to shift some money from equity to fixed income. A good solution is hybrid funds. In fact, a hybrid fund in which the debt-equity split matches your desired asset allocation is the most stable investment. It should require virtually no selling till the time you need to redeem it.
There’s an interesting caveat to this, one that few investors realise. It’s the NPS Tier 2 account. This account is basically a collection of low-cost mutual funds that are available to the NPS Tier 1 members. Unlike Tier 1, they can be bought and sold like any other fund. However, you can shift from one plan to another, and thus change your asset allocation, without incurring any capital gains tax. Every mutual fund investor who is a part of the NPS Tier 1 account should study Tier 2 closely and consider these funds as a choice available to them.No matter which part of the above discussion applies to you, mutual fund investors need to be fully aware of the tax implications of their investment choices. It’s not something you can ignore any more.The Author is CEO, VALUE RESEARCH