Assessing Tax impact while choosing investments

Reduce tax impact on Debt Mutual Funds

In the last couple of years some changes made in tax rules for dividends in mutual funds have made the dividend option of debt plans very unattractive. While dividend distribution tax has been done away with, mutual funds now deduct TDS (10%) and Stamp duty (.005%) every time dividends are paid and reinvested respectively. Besides the dividends are fully taxable in the hands of the investor.

Clearly dividend options is not an option anymore and as an investor you must ensure you move lock stock into the growth option

Short term capital gains (if the units are sold before three years) in debt mutual funds are taxed as per applicable tax rate of the investor. Therefore, if your tax rate is 30% then short term capital gains tax on debt fund is 30% + 4% cess. Long term capital gains of debt fund are taxed at 20% with indexation. With some management , the overall effective tax payout can be brought down considerably.

Let me explain with an example. Astute investor Mrs. A has been saving money in HDFC low duration fund since 2017. This is the list of her transactions

Transaction Date	Type	Transaction price	Amount invested	Units	Capital Gain	Capital Gain type	Tax payable
July 25 2017	Buy	36.3758	100000	2749.08
January 15 2020	Buy	43.5275	100000	2297.40
June 25 2017	Sell	45.2692	-50000	-1104.50	9822.8	Short term	3241.522
July 27 2020	Sell	45.773	-50000	-1092.35	10265.0	Long term	1326.281

 

 Note the difference in tax amounts in a matter of just one month. Tax on units sold in July is less than half the tax paid on units sold in June.

I point out to Ms. A that she should have waited a month to make the withdrawal .But an astute investor that Ms. A is, she asked me why even sell the longer term units and that she should be allowed to sell from units purchased in Jan 2020. She shares the following chart if she is allowed to sell units bought in Jan

Transaction Date	Type	Transaction price	Amount invested	Units	Capital Gain	Capital Gain type	Tax payable
July 25 2017	Buy	36.3758	100000	2749.08
January 15 2020	Buy	43.5275	100000	2297.40
June 25 2017	Sell	45.2692	-50000	-1104.50	1923.7	Short Term	634.8257
July 27 2017	Sell	45.773	-50000	-1092.35	2452.9	Short Term	809.4455

 

She points out she would end up paying on Rs. 1445 in taxes, if the units purchased in Jan 2020 are sold, versus Rs.4568 if she withdraws her older units.  She is right. However Ms. A made the Jan investment in the same folio as her previous purchase. As per tax law, tax on units sold follows the FIFO (First in First out) method to calculate purchase cost. Sadly she will end up paying three times the tax because she did not plan her withdrawals.

How could Mr. A Plan her investments and withdrawals to ensure minimization of tax.

1.      She can bunch her debt purchases in a single fund /single folio in short periods of time. For those with a high frequency of purchases use a three month to six month time frame to add in a single fund/single folio. Thereafter either use another folio (if u want the same plan) or spread your investments over several fund houses in similar themed funds. In our example Mr. A should have made the Jan purchase in either a different scheme or a diff fund. That would have separated her recent purchase from the older one

2.       Always withdraw from the latest investment done .Your youngest investments will have the least accumulated capital gains and also u will give time to your older investments to become long term (complete  three years)

Going forward, for my clients  I plan to accumulate funds in one liquid fund and thereafter move them to more than one different longer debt fund. Client's Debt portfolio will look like it has a lot more funds than in the past and will need some study of ageing before transactions are done. 

In case of withdrawals it is best to contact your investment advisor and they will advise and help you execute the sale/redemption or you must maintain a ageing chart of investments .You may check the date of purchase to ensure that you sell your most recent purchases and aren’t selling any units that are close to completing three years.