Mutual Funds - The tax angle |
July, 2001 |
When it comes to tax planning in case of mutual funds, the most obvious option may not always be the best option. Investors seeking a regular income from mutual funds usually opt for the dividend option. They assume that the tax-free dividend payout is more efficient than systematic redemption of units from a growth option-but that may not be the case. There are many interesting aspects to mutual fund investing where the obvious choice may not always be the best.
The tax provisions, whatever they are, are unavoidable. However, there are some general observations that are required to be understood as they can lead to a lowering of the tax liability. The choice, quite obviously, has to be made by the investor himself depending on his needs. Listed below is a check list which the investor should keep in mind before deciding his options in case of investing in a mutual fund.
Double Indexation Benefit – In some cases it is better to aim for the double indexation benefit rather than pure tax free income. When calculating the capital gains in case of redemption of units, an investor can calculate capital gains by choosing between two options - 10 per cent without indexation or 20 per cent with indexation. An investor, at the time of withdrawal, should consider both and choose the lower tax option. At this point the concept of double indexation can be useful.
Double indexation gives an investor the advantage of indexing his investment to inflation for two years while remaining invested for a period of slightly more than an year. This can be done if the investor puts in his money just before the end of a financial year and withdraws it immediately after the end of the next financial year. For instance, had an investor put in money in a fund on 25 March 2001 (6 days before the end of FY on 31 March 2001) and withdrawn it on 5 April 2002 (after the end of FY 2001-2002) he would have got benefit for two financial years (2000-01, 2001-02) since the investment was made in the FY before last (2000-01). Depending on the quantum of gains in the scheme and the inflation index, the tax liability could be lowered by availing of double indexation.
Switch options carefully- switching options-dividend to growth or vice versa-amounts to redemption from one option and fresh investment in the other option. And, this redemption attracts capital gains tax. So, it is important that an investor chooses the option carefully. This can be done through a careful analysis of one's cash flow needs.
How bonus units lower capital gains- Unlike the case with common stock, a bonus issue in mutual funds carries nothing but a liquidity and tax advantage and that too under a given set of assumptions. A bonus carries no value because the total wealth of the unitholder remains the same. However, as the NAV adjusts down, depending on the ratio in which the bonus is granted, it serves to lower the cost of exit on the existing units. In short it reduces capital gains payable. A bonus issue could, therefore, partially increase liquidity by facilitating early withdrawal for those fearing to redeem on account of tax liability. The flip side ofcourse is that the cost of bonus units is deemed to be zero for tax purposes and that whenever those are withdrawn a tax will be levied on the gains.
So, while less tax on existing units is compensated for by greater tax liability on bonus units (because their value is deemed to be zero), the advantage is that withdrawal of existing units can be made even before the end of one year. This is because any gains in the units may have been reduced if not eliminated altogether due to the bonus issue.
When systematic withdrawal is better than dividend receipts-the prevailing tax provisions provide an interesting way of not only receiving regular income but also paying less tax. This can be done by systematically withdrawing the gains from the investment instead of claiming dividends. To do this an investor needs to opt for the Growth option of a mutual fund scheme and stay invested in the scheme for atleast one year. After one year, the investor can direct the mutual fund to systematically redeem units worth a fixed amount or units equivalent to the gains in the scheme.
This way, the investor is assured of regular inflows. The benefit of doing this is that it is a more tax efficient way of receiving regular income. This is because whenever the units are withdrawn capital gains is charged on the difference between the purchase price and redemption price. So, if an amount equivalent to the gains is withdrawn then tax is levied on the amount of gains less the cost of units being redeemed to distribute this gain. Had these gains been distributed as dividend, tax would have been levied on the entire amount of gains. This would have meant a higher tax payout.
Dividend Reinvestment –the right choice for open-end equity schemes - tax laws prevailing at the moment specify that dividend payouts of all funds except UTI's US 64 and open ended equity schemes are subject to a distribution tax of 10 percent. This exemption granted to open end equity funds can be turned to one's advantage. An investor can take advantage of this provision by investing in the dividend reinvestment option of the scheme.
The benefit of this is that due to the dividend declared in the units of the scheme the NAV declines by the amount of dividend.This, then brings down the redemption price of the units which in turn lowers the amount of capital gains. The advantage of dividend reinvestment therefore is twinfold. One, is that the amount of gains reduce and other is that dividend gets reinvested in the scheme automatically without any fresh procedural hassles.
Invest for the long term - apart from being one of the fundamental tenets of sound investing, investing for the long term is also smart from the tax angle. Units held for more than an year are eligible for long term capital gain unlike short term capital gain which is taxed as a part of the unitholder's total income. While the maximum tax that will need to be paid on long term gain is limited to 10 per cent, tax on short-term capital gain can vary depending on other components of the unitholder's total income.
Aru Srivastava
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