How Tax Free is your Investment|Earning Returns or Paying Taxes

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The very first thing that comes to our minds on the term ‘Tax’, is Income Tax and how to save it. Every year most of the working class especially the youth find themselves lost in the fields of their Investment declaration form, not knowing what to fill where and how to save their tax, TDS to be specific, asked to submit ASAP the next day being the last day always by the nerdy accountant of their organisations.

Most of us only relate to taxation being income tax that generates from your regular income viz. Salary or earnings from your business if you are an entrepreneur. The basic myth is that TDS is your tax liability which is not true. Your tax liability can be much more or even less than the TDS being deducted or calculated. There are various other forays of income that can elevate your tax liability; something that you are honestly expected to declare while filing Income Tax Returns (ITR).

Just like you have various sections other than 80C for claiming tax rebate, there also are sections for declaring taxable incomes viz. sale of assets i.e. Property (Real Estate), Gold etc; financial trading i.e. Mutual Funds, Stocks, Bonds etc. In short earnings from these sources are known as Capital Gains and the tax applicable is called Capital Gains Tax.

Taxes levied on Capital Gains are different and subject to type of the Asset being sold. And, it has nothing to do with your professional income slab or nature.  The good thing is Capital Gains Taxes are much less than your Income tax.

Cutting long story short, let’s discuss the taxation process on two major financial assets (Investments) and how they work.

1.        Fixed Deposit Although Fixed Deposits are not considered as capital financial assets, I am discussing it here as we all have ended paying TDS on our returns from this conventional investment instrument. Income generated from a FD is considered as normal income and taxed at your income level irrespective of the tenure of the FD.

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e.g. If you are in the 30% tax bracket and your bank is giving you a 7% interest on your FD, your tax liability is 30% on that interest i.e. 30% of 7% = 2.1%. So your actual after-tax interest rate is just 7 – 2.1% = 4.9%

Similarly, if you are in the 20% tax bracket, your after-tax FD returns are going to be 7% – (20% of 7%) = 5.6%.

Banks are liable to deduct TDS at the rate of 10% on the interest earned, if the interest income for the year is more than Rs. 10,000.

2.        Mutual Funds Mutual Funds invest in various assets like stocks, bonds, gold etc. so their taxation depends on the type of Mutual Fund.

From a taxation perspective, there are only two kinds of Mutual Funds – Equity Mutual Funds and Non-Equity Mutual Funds.

Also note that tax liability is the same for resident Indians as well as NRIs.

(a)       Equity Mutual Funds. The taxation of Equity Funds is similar to stocks. Along with stocks they are the most leniently taxed investments. Where holding period is less than 01 year, the gains from the sale of your Equity mutual fund units will be marked as Short Term Capital Gains (STCG). STCG will be taxed at 15% flat (irrespective of your income tax level). That is even if you are in the 30% tax bracket; short-term profits booked from Equity Mutual Funds will be taxed at only 15%. If the holding period is more than 01 year, the gains will be marked as Long Term Capital Gains (LTCG). Tax on LTCG for Equity Mutual Funds is ZERO. There is no tax liability at the end of the year for just holding your Mutual Fund units while they increase in price.

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Bottom-line, irrespective of how much wealth you make over your lifetime by investing in Equity Mutual Funds, you don’t have to pay anything in taxes as long as you held each fund patiently for more than 01 year.

TDS !?

For resident Indians, no TDS is deducted on the sale of Mutual Fund units, whether short-term or long-term. Any (short-term) capital gains tax liability has be to paid by you on your own.

For NRIs, TDS at 15% will be deducted for redemption from equity mutual funds within 1 year (Short Term) whereas no TDS will be deducted for sale of equity mutual fund units held for more than a year (Long Term).

(b)       Non-Equity Mutual Funds (Debt funds of all types – liquid, short term, hybrid funds etc).   The taxation here is not as lenient as Equity Mutual Funds, however still making it better than Fixed Deposits, especially in the long terms. Where holding period is less than 03 years, the gains will be marked as Short Term Capital Gains (STCG). STCG from Non-Equity Mutual Funds is clubbed with your total income and taxed at your income tax level. If the holding period is more than 03 years, the gains are marked as Long Term Capital Gains (LTCG). LTCG from Non-Equity Mutual Funds also qualify for Indexation benefit viz. in order to compute your gains, instead of using your actual purchase price you can use a higher Inflation-Adjusted price.

LTCG = Sale price – (actual purchase price + inflation over the holding period)

Tax Liability = 20% of the LTCG computed above (irrespective of your income bracket).

Because of the indexation benefit, LTCG can be significantly lower than the actual gains, thus lowering your tax liability by a lot; in some cases even ZERO when the gains are less than inflation.

TDS !?

For resident Indians, no TDS is deducted on the sale of Mutual Fund units, whether short-term or long-term. Any (short-term) capital gains tax liability has be to paid by you on your own.

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For NRIs, TDS at 30% will be deducted for redemption from non-equity mutual funds within 03 years (STCG) and in case of LTCG; TDS at 20% with indexation will be deducted for sale of debt mutual fund units held for more than 03 years.

Debt Funds and Fixed Deposits – More Taxes or More Returns?

Debt Mutual Funds are 10 times more tax efficient than Fixed Deposits while providing similar safety and returns because of indexation benefits.

In FD all gains are taxed at your current income tax level irrespective of how long the FD was kept for.

E.g. If you are in the 30% tax bracket, a 05 year FD at 7% p.a. will levy a tax of 30% of 7% = 2.1%. So your post tax returns will be 7% – 2.1% = 4.9% only.

Same investment made in say a Short Term Debt Mutual Fund for 05 years will be eligible for indexation under Long Term Capital Gains.

e.g. Inflation during those 05 years = 6%; Your tax liability will only be 20% of (7% – 6%) = 0.2%

Hence, your effective post tax returns will be 7%-0.2% = 6.8%

If inflation is 7% or more, then the taxes will be ZERO.

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