Assess The Tax Efficiency Of Your Returns

Hemant Rustagi
CEO, Wiseinvest Advisors 

While most investors ignore the tax efficiency of their investment returns, it is important to consider this aspect especially in medium to long-term investments, says Hemant Rustagi as he suggests ways of enhancing post tax returns

Every investor has a unique investment style and strategy. While some begin their investment process with a clear strategy and objectives, others learn it the hard way. However, an important aspect of the investment process that is often overlooked by investors in both the categories is the tax efficiency of their investment returns.

It is no wonder then that the traditional instruments like bank deposits, bonds, debentures and small saving schemes remain the most favoured options for millions of investors in our country. What is surprising is that they do so despite the fact that for most of these instruments they are required to pay taxes at their nominal rates. In fact, investors compromise on the returns too.

Although it is quite natural to be concerned about the safety of one’s hard-earned money, putting too much emphasis on this aspect alone can make a huge difference to the final result. Investors’ reluctance to look beyond these traditional investment options restricts their growth as an investor.

Therefore, tax efficiency has to be an essential element of your investment strategy. It becomes even more important when you invest for medium to long-term investment goals such as children’s education, buying a house and retirement planning.

One of the ways to enrich post tax returns is to invest in tax-efficient options like mutual funds. More importantly, mutual funds offer a variety of funds in each of the asset classes like equity, debt and gold. As per the current tax laws, dividend paid by equity as well as debt funds are tax free in the hands of investors. However, for debt funds, mutual funds are liable to pay a Dividend Distribution Tax (DDT). 

On the capital gains front, short-term capital gains in an equity fund (gains on investments redeemed within 12 months from the date of investment) are taxed at a flat rate of 15 per cent. However, long-term capital gains (gains on investments redeemed after 12 months) are tax free. As regards debt funds, short-term capital gains are taxed at an investor’s applicable tax rate, and long-term capital gains are taxed at a concessional rate of 10 per cent (without indexation) and 20 per cent (with indexation).

Another important consideration is to select the right option - dividend, growth or dividend re-investment. If you intend to invest for the long term, the obvious choice should be the ‘growth option’. It allows you to benefit from the power of compounding as well as tax efficiency. However, if you are looking at investing in a debt fund with a time horizon of less than 12 months, you need to be careful while selecting the option. If you fall under the highest tax bracket of 30 per cent in spite of the recent hike in DDT to 25 per cent, the dividend payout remains attractive. However, if you are liable to pay tax at 10 or 20 per cent, the growth option would be more tax efficient.

Therefore, investing with a clearly defined time horizon can help you make the right choices. It is equally important for you to minimise your portfolio turnover to improve the tax efficiency of your returns. To do so, you must follow the right strategy. First, by assessing the tax consequences before making abrupt changes in the portfolio and resisting the temptations to sell investments for reasons other than poor performance and changes in your personal circumstances, you can reduce the tax burden.

Second, you must try to make the right selection of investment options to minimise the need to make changes in the portfolio in the short term. Third, by honouring your time commitment, you can avoid making haphazard decisions. This will also help you in tackling market volatility from time to time. 

Lastly, by following the strategy of portfolio re-balancing once a year, you can not only book profits in equities in a disciplined manner during good times but also invest in it when the chips are down. Needless to say, this approach has the potential to ensure that you get to keep more in the end.