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How Investing in Mutual Funds Saves Tax February 16, 2011
From exemption under Section 80C to indexation benefits, tax free dividends and indexation on capital gains, mutual funds offer you the perfect avenue to reduce your tax burden while creating wealth.
Author : iFAST Content Team


Untitled Document

Key Points:

  1. Government offers special tax benefits on investments in mutual funds to encourage the habit of savings and investments in retail investors.
  2. Mutual funds come with tax benefits like tax free dividends, indexation benefit on long term capital gains, and exemption under section 80C. This makes MFs a more attractive option than traditional deposits and post office schemes.

Read on to know more..

The principle behind taxation is simple – wherever value is created, a part of it has to go to the government as tax. Therefore, when we earn our income, tax has to be paid. Similarly, when money is invested, there is taxation on any interest or dividend income earned by such investment, and also on the increased value of the initial capital at the time of encashment.

To encourage the habit of savings and investments in wage earners, the government offers tax exemptions on some choice instruments like provident fund, insurance policies and mutual funds. Generally, amounts invested in these instruments, as well as interest income earned on the same are exempt from tax. But mutual funds, being specifically encouraged as investment products for retail investors, come with certain additional tax benefits. This article discusses the same.

Tax Free Dividends: Dividends declared by all mutual funds are tax-free in the hands of the investors. However, non-equity funds pay a dividend distribution tax before paying out dividend – only funds that invest over 65% of their corpus in Indian equity are exempt from this tax. Non-equity funds (apart from liquid and money market funds) pay a dividend distribution tax of 14.163%, whereas liquid and money market funds pay a dividend distribution tax of 28.325%.

Long Term Capital Gain Tax: Capital gains on sale of equity mutual fund units more than a year after purchase incur zero capital gains tax. For non-equity mutual funds, the long-term capital gains tax rate is 10% without indexation or 20% with indexation. This is beneficial to you since you have the option of taking into account the effect of inflation on the purchase price of mutual fund. This advantage is not available in other traditional options like fixed deposits.

For example, if you invested Rs. 100,000 in a fixed income mutual fund in Financial Year (FY) 2007-08 i.e., between 1 April 2007 and 31 March 2008 and sold the units for Rs. 135,000 in FY2010-11, your capital gain without indexation is Rs. 35,000 and you stand to pay Rs. 3,500 as tax. [Our illustration assumes a CAGR of 7.75% over 4 years on this fund.]

However, let’s consider the indexed purchase price, which is derived by using the Cost Inflation Index for the year of purchase and sale. The Cost Inflation Index figure is a factor that allows you to compute the current value of a sum of money taking into account the effect of inflation.

Indexed Purchase Price = Purchase Price X (CII of Current Year/CII of Purchase Year)

In our case, this is: 100,000 X (711#/551) = Rs. 129,038 (which means that in 2011 terms, the cost of your investment is Rs. 129,038)

Capital gain with indexation = Rs. 5962

Long Term Capital Gains Tax with indexation = Rs. 1192

Calculation of long term capital gains tax (with and without indexation benefit)

 

FY2008

FY2011

 

 

 

Cost Inflation Index

551

711

Gain

Indexation

Tax

Value of Investment amount

100000

135000

35000

Without Benefit @ 10% (A)

3500

Inflation adjusted value at present

129038

135000

5962

With Benefit @ 20% (B)

1192

 

 

 

 

Saving (A-B)

2308

This saving of Rs. 2308 in tax would not be possible on other fixed income instruments that do not offer the option of indexing the cost price. The following illustration shows the comparison of tax payable with a fixed deposit.


Illustration: Comparison between investment in a fixed deposit and fixed income mutual fund

 

Fixed Deposit

Mutual Fund

Purchase amount FY 2008

100000

100000

Accumulated amount FY2011(Y)

135000

135000

Inflation adjusted Cost of Investment (X)

135000

129038

Indexation

Fixed Deposit

Mutual Fund

Saving (A-B)

Gain (Y-X)

35000

5962

 

Tax with Indexation Benefit

-

1192 (B)

Tax@30% (A1)

10500

-

9308

Tax@20% (A2)

7000

-

5808

Tax@10% (A3)

3500

-

2308

 

 

 

 

 

 

 

Double Indexation Benefit with Fixed Maturity Plans: Fixed Maturity Plans (FMPs) are fixed term, closed-ended schemes that invest in fixed income instruments of various durations. The durations of FMPs are slightly over a year, and they are usually issued around February/March; currently this allows investors to gain indexation benefit of two financial years, whereas they actually hold the plan for slightly over 12 months. So, a 14-month FMP purchased in February 2011 will mature in April 2012, spanning three financial years – 2010-11, 2011-12 and 2012-13. At the time of redemption in 2012, the investor will be able to gain indexation benefit for the years 2010-11 and 2011-12. You can read more about FMPs here.

It is important to note however, that the proposed Direct Tax Code, which is expected to replace the current tax structure from April 2012, will take away this double indexation benefit. According to DTC, investors in an FMP will be able to consider indexation only from the financial year following the year in which they purchase the units. Continuing our previous example, if you purchase the 14-month FMP in February 2011, you can consider indexation only for financial year 2011-12. However, even with this modification, FMPs will continue to offer indexation benefit like other fixed income mutual funds, and offer more tax savings compared to fixed deposits.


Exemption under Section 80C
: Amount invested in Equity Linked Savings Schemes (ELSS) is exempt from taxation under section 80C up to Rs. 1 lakh. Also, if you opt for the dividend reinvestment option in an ELSS, every set of units added is considered to be a fresh investment and is included while calculating income exempt from tax. It is important to note however that ELSS funds have a lock-in period of three years. So, in case you invest in an ELSS fund using an SIP or dividend reinvestment option, each instance will be locked in for three years from the time of investment.

Setting off Capital Losses: Any short term capital loss incurred on the sale of mutual fund units can be set off against any taxable long-term or short-term capital gains that you may have made that year. A long-term capital loss can be set off only against taxable long-term capital gain.


However, in the case of dividend payout schemes, or schemes issuing bonus units, the following should be noted:

  1. In the case of dividend payout options, loss incurred on sale of units of that scheme cannot be set off against another capital gain (to the extent of dividend declared) if:
    1. Units are bought up to three months before date of dividend declaration
    2. Units are sold within nine months of dividend declaration
  2.  In case of bonus units issued, any loss on the sale of the original units will not be available for set off if:
    1. Original units are bought up to three months before date of bonus issue
    2. Original units are sold within nine months of bonus issue

Such loss on sale of original units can be considered as cost of the unsold bonus units.

Example

(Do note that the topic of taxation relating to capital gains and losses is more vast and technical than can be shown through this illustration. Please do consult tax experts for a fuller understanding.)


 Fund/Asset Name*

Year of Purchase

Cost

Sale Value#

 Capital Gain

Capital Loss

Long Term/Short Term

HSBC Progressive Themes Fund

Feb 2008

100,000

87,960

12,040

Long term

ICICI Prudential Technology Fund

Sep 2010

100,000

109,790

9,790

 

Short term

Fidelity Equity Fund Growth

Feb 2009

100,000

142,680

42,680

 

Long term

Reliance Natural Resources Fund

Nov 2010

100,000

90,280

9,720

Short term

HDFC MIP Long Term Plan

Feb 2008

100,000

110,740

10,740

 

Long term

* Fund names used only for illustration, and not meant to promote or in any way depict our opinion on the funds. #: Sale value has been computed based on 3 month, 6 month, 1 year, 2 year and 3 year returns on these funds as at February 11, 2011. Source: Fundsupermart.com


Your tax working will be as follows:

  1. You have a long-term capital loss (LTCL) of Rs. 12,040. This can only be set off against taxable long-term capital gains (LTCG). Since the LTCG of Rs. 42,680 was made on equity fund, it is exempt from capital gains tax and cannot be used for setting off capital loss. Therefore, the LTCL of Rs. 12,040 can be set off against Rs. 10,740 (taxable capital gain from non-equity fund) – making your taxable LTCG zero. The balance capital loss of Rs. 1,300 can be carried forward to the next year.

  2. The short-term capital loss (STCL) of Rs. 9,720 can be set off against both, LTCG and short-term capital gains (STCG). Your LTCG has already been exhausted in setting off LTCL, and you now have STCG of Rs. 9,790 which can be used for setting off. Effectively, you are then left with STCG of Rs. 50 which will be taxed @ 15%.

We therefore see that with the possibility of setting off capital losses is also effective in reducing tax liabilities.


Conclusion

Taxation implications form an important parameter when evaluating an investment product; higher the amount, or longer the duration of investment, greater is the impact of tax on your net returns. With the benefits of exemption, tax-free income and indexation on capital gains, mutual funds offer many avenues of maximising your returns.

# Cost Inflation Index for the year 2010-11 has been notified by the government vide notification number 59/2010, dated July 21, 2010. Source: www.etaxindia.org


Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website. Risk Factors: Mutual funds, like securities investments, are subject to market risks and there is no guarantee against loss in the Scheme or that the Scheme’s objectives will be achieved. As with any investment in securities, the NAV of the Units issued under the Scheme can go up or down depending on various factors and forces affecting capital markets. Past performance of the Sponsor/the AMC/the Mutual Fund does not indicate the future performance of the Scheme. The name of the Scheme does not in any manner indicate the quality of the Scheme, its future prospects or returns. Please read the Statement of Additional Information and Scheme Information Document carefully before investing.



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