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How to handle capital gains on equity MFs through systematic exits

05 Jan 2023

The Union Budget 2018 has added a new dimension to the aspect of capital gains tax on equity mutual funds. One of the big attractions of equity mutual funds was that the long term capital gains were entirely tax free. The Union Budget 2018 has now imposed tax on long term capital gains if the total capital gain in the year exceeds Rs.1 lakh. The capital gain in excess of Rs.100,000 during the year will attract tax at the flat rate of 10%. Of course, there will also be the surcharge of 4% making the effective tax rate 10.4%. What also needs to be remembered is that there is no benefit of indexation available. The definition of capital gains is still holding period of more than 1 year. But, irrespective of whether the LTCG arises after 1 year or after 5 years, the tax on LTCG has to be paid at a flat rate of 10% where the LTCG exceeds Rs.1 lakh per year. Let us look at a capital  gains tax calculator India and also at a tax efficient systematic withdrawal plan.

Does the tax on long term capital gain really make a big difference?
Let us actually understand this point with a live example of an equity fund that is held for more than 1 year. We will evaluate the impact of the LTCG tax under three circumstances viz. prior to Union Budget 2018, post Union Budget 2018 assuming that the limit of Rs.1 lakh is not utilized and Post Union Budget 2018 assuming that the limit of Rs.1 lakh is already utilized.

ParticularsPre Union Budget 2018 scenarioPost Budget – But 1 lakh limit not usedPost Budget – But 1 lakh limit already usedUnits of ABC Equity Fund (Growth Plan)1000 units1000 units1000 unitsNAV on Jan 01st 2018Rs.15Rs.15Rs.15NAV on Feb 01st 2019Rs.18Rs.18Rs.18Return on ABC Fund20%20%20%LTCG on ABC FundRs.3Rs.3Rs.3Total Long Term Capital Gain (LTCG)Rs.3,000Rs.3,000Rs.3,000Tax on LTCGNilNilRs.312Post Tax LTCGRs.3,000Rs.3,000Rs.2,688Post Tax Yield20%20%17.92%

As the above table suggests even if you consider that the entire LTCG on sale of equity funds becomes taxable at 10.4%, your overall post tax return reduces by just about a little over 200 basis points. The point is that the post tax return of 17.92% is still quite attractive when you compare with other investment avenues. So the tax on LTCG on equity funds is not something for you to really worry about. Yes, it will reduce your post tax  yield (in the above case b over 200 bps) but the post tax return is still quite attractive. The only difference is that you need to rework your long term goals accumulation and rework your monthly allocations accordingly.

Can we do systematic exits to minimize the tax impact?
In our previous illustration we assumed that the entire units purchased were sold on the completion of 1 year. But when tax is imposed on LTCG, investors are going to phase out their selling. When you sell partial units, a major chunk of your redemption is in the form of capital redemption and only a small portion is in the form of LTCG. Let us understand this with an illustration. Let us also assume that the limit of Rs.100,000 has already been utilized so LTCG on equity funds is now taxable..

Particulars of the Equity FundAll the units are soldPartial units are soldName of the FundXYZ Equity Fund (Growth)XYZ Equity Fund (Growth)NAV on 01st Jan 2018Rs.10Rs.10NAV on 01st Mar 2019Rs.12Rs.12Return on investment20%20%Number of Units owned10,000 units10,000 unitsNumber of Units sold10,000 units2,000 unitsRedemption ValueRs.120,000Rs.24,000Profit on sale of unitsRs.20,000Rs.4,000Tax payable on LTCT at 10.4%Rs.2,080Rs.416

What we are doing in the 2nd case is that instead of selling all the units, we are only selling partial units. As a result, part of the money comes to you as principal and part as LTCG. Thus by phasing your withdrawal in the second case, you have substantially reduced your tax outgo on LTCG. The fiscal year ends on March 31st 2019. On April 01st you can sell the balance units in the second instance and pay not tax as you are within the Rs.1 lakh limit. That is how phasing your selling can help you.

Summarizing ways to minimize your LTCG tax on equity funds
There are 3 things that investors in equity funds can do to reduce their tax outgo on LTCG..

You can just avoid selling units and hold on in the hope that in the next couple of years the government may see the futility of imposing tax on capital gains and withdraw the same. Of course, you are taking a regulatory bet here.

The second way is to adopt the phased approach and ensure that you make the best of the limit of Rs.1 lakh. You can also spread your profits across different financial years to make the best of the limits.

Lastly, there is always the facility of writing off your capital losses against your capital gains and you need to pay tax only on the net LTCG. That is another facility that is available to you.

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