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How saving taxes can help you enhance your wealth

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11 Feb 20206 mins readBy MOFSL

Most investors tend to underestimate the importance of tax in your post-tax returns. When it comes to long term wealth creation, the tax liability and the tax treatment makes a huge difference. Let us understand how to save money on taxes and how to reduce income tax. We are also providing an income tax saving calculator under different circumstances. The crux of the issue is that you need to factor in the tax implications to be able to get a precise hang of the post tax wealth creation. Here are 4 different scenarios you need to understand pertaining to mutual funds..

1.  Diversified equity fund versus ELSS Fund

An ELSS fund is nothing but an equity fund with a 3 year lock in. The added advantage is that your investment in an ELSS fund in any year entitles you to a tax exemption up to Rs.150,000 per year under Section 80C of the Income Tax Act. Let us look at the case of an investor who invests Rs.150,000 in an equity diversified fund and another investor who invests the same amount in ELSS Fund. Let us look at the impact with and without Section 80C benefit.

 

Diversified Equity FundAmountTax-saving
ELSS FundAmountTax Break ReinvestedAmountDate InvestedApr 01, 2016Date InvestedApr 01, 2016Tax Break33.99%InvestmentRs.1,50,000InvestmentRs.1,50,000Value of BreakRs.50,985Annual CAGR14%Annual CAGR14%Annual CAGR14%RedemptionApril 01, 2019RedemptionApril 01, 2019Period2 YearsValue at endRs.2,22,232Value at endRs.2,22,232Final ValueRs.66,260

Final Value of ELSS InvestmentRs.2,88,492

 

As can be seen from the above table, when you get exemption under Section 80C, the tax break acts as your income and that can be reinvested for the remaining period at the same yield. As a result the net return generated by the ELSS in rupee terms is 91% more than that which a diversified equity fund can generate. This is despite the fact that both have invested the same amount in the same asset class yielding the same returns.

 

2.  Taxable FDs versus tax-efficient debt funds
In the first case we saw the impact of tax exemption. Now let us look at the impact of taxation of the returns on the investment. Let us compare a bank FD for a period of 4 years with a debt investment for the same period. Let us also conservatively assumes that the FD yields 8% annual returns and the debt fund yields 9% annual yield. How they compare at the end of 4 years.
 

InstrumentAmountInstrumentAmountBank FD InvestmentRs.5,00,000Debt Fund (Growth Plan)Rs.5,00,000Annual interest rate8%Annual yield9%Annual Interest payableRs.40,000Value after 4 yearsRs.7,05,791Income Tax at 33.99%Rs.13,596Pre Tax gain on debt fundRs.2,05,791Post Tax Interest earnedRs.26,454Indexed Gains (1.23 cost)Rs.90,791Post tax gains for 4 yrsRs.1,05,816Tax at 20%Rs.18,158

Post Tax gains for 4 yrsRs.1,87,633

 

In the above table, the debt fund just gives 1% more than the FD, but the real difference comes in the tax treatment. In case of FDs, each year the interest is taxed at the peak rate of 33.99% (including cess and surcharge). But in case of debt funds, the capital gains are taxed at just 20% after indexation. Over a 4 year period, the returns on a debt fund in post tax terms are 77% higher than a bank FD.

 

3.  Dividend plan versus growth plan

In case of dividend and growth plans, there are different implications for equity funds and debt funds. In case of equity funds, there is parity effective the budget 2018. While dividends paid out by equity funds will be tax free in the hands of the investor, it will attract dividend distribution tax of 11.64%. Similarly, the long term capital gains on equity funds will also attract flat tax of 10% above Rs.1,00,000 per annum without the benefit of indexation. In case of debt funds, the growth plan continues to be more attractive. That is because LTCG on debt funds (beyond 3 years) is charged at 20% after indexation while dividends attract dividend distribution at 29.12%

 

4.  Equity Fund versus debt fund post the 10% tax on LTCG

There is a very interesting question on whether the debt funds have become more attractive in post terms post the 10% LTCG on equity fund profits. Let us look at a case study and for simplicity let us assume that both the equity and debt funds give 10% CAGR returns

 

Debt FundAmountEquity FundAmountHolding Period5 yearsHolding Period5 yearsBuying CostRs.5,00,000Buying CostRs.5,00,000CAGR Returns10%CAGR Returns10%Value after 5 yearsRs.8,05,000Value after 5 yearsRs.8,05,000Indexed cost of purchaseRs.6,80,000Capital  Gains exemptionRs.1,00,000Taxable Capital GainsRs.1,25,000Taxable Capital Gains2,05,000Tax at 20%Rs.25,000Tax at 10%Rs.20,500

 
As can be seen from the above illustration, when equity funds do not outperform debt funds by a good margin, the post tax returns are approximately the same. That is because of the 10% tax on LTCG on equity funds without the benefit of indexation. That has actually put debt funds at an advantage vis-a-vis equity funds.
 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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