Mutual fund investors need greater tax awareness

Even though the newly proposed tax on property sales is being reduced, long-term capital gains tax on stocks and mutual funds is now a settled fact. It's been seven years since this tax was introduced, and the only change that has happened so far is that this year, the rate has increased from 10 per cent to 12.5 per cent. This is now a uniform rate for not just stocks and equity mutual funds but for many other types of investments. However, that's where the similarity ends. For investors who want to earn long-term returns and build real wealth from equity-based assets, the tax structure means that significant attention must be paid to what they invest in and when they buy and sell those investments.

The single biggest thing to be aware of is that it's far more beneficial (from the 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 budget has made it that much more important. In any case, even earlier, many investors did not appreciate this about taxation.

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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 can hold most of your stocks for many years. Time goes by, circumstances change, companies and markets evolve, and formerly good stocks have to be sold and something better bought. If you are investing in stocks yourself, then these transactions will mean a tax liability.

However, in an equity mutual fund, the fund manager does the equivalent trading inside the fund. You don't have a tax liability because you haven't made transactions yourselves. Moreover, this is not just about the tax amount itself. Over time, the bigger impact comes from the future growth of that money. You might pay (hypothetically) a couple of lakhs of long-term capital gains this year, but if you did not have to do that, then five years down the line, that money could be Rs 5 lakh. That's a further multiplier to the tax saved because the money stays available as an investment and thus gains even more. For long-term investments that compound over the years, this can make a huge difference. Obviously, for this compounding to happen at all, you must be invested in an asset type which does not require you to buy and sell yourself too frequently and that's basically diversified equity funds. You might wonder why I'm saying diversified in particular. The reason, again, is that sectoral, thematic or other specialised funds will likely need you to adjust holdings more often, while diversified funds will not.

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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. The cure for this is hybrid funds. In fact, a hybrid fund whose debt-equity split matches your desired asset allocation is the most stable investment that you can make. It should need practically no selling till the time you actually need to redeem it to use the money.

There's a caveat to this and a very interesting one which few investors realise and that's NPS Tier 2. NPS Tier 2 is basically a collection of low-cost mutual funds that are available to 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 becoming liable for capital gains tax. I would suggest that every mutual fund investor who is part of the NPS Tier 1 should study Tier 2 closely and consider the available funds to be part of the mutual fund choice available to them.

Anyhow, no matter which part of everything that I've discussed applies to you, mutual fund investors need to have full awareness of the tax implications of their investment choices. It's not something you can ignore any more.

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