LTCG tax and your investments

The proposal to tax long-term capital gains from equity funds has miffed investors. Their returns will now be lower. This could change the way people invest their savings. For instance, equity-linked savings schemes (ELSS) could lose the tax-free status that made them among the favoured options to save tax. Given that equity funds will not be allowed indexation benefit, the tax disparity between equity and debt schemes has narrowed, making debt funds and FMPs more attractive now.
Don't shun ELSS
The Public Provident Fund (PPF) and Ulips will continue to be tax-free while the gains from ELSS funds will be taxed at 10%. But experts say investors should not shun ELSS. Being pure equity-based instruments, ELSS can generate higher returns, making them ideal long-term investments, irrespective of the new tax. Rohit Shah, Founder and CEO, Getting You Rich, asserts, "ELSS remains lucrative as post-tax returns will be greater than PPF and high cost Ulips."
Low cost Ulips, sold online by insurance firms, can provide returns comparable with ELSS over the long term. But unlike Ulips, ELSS offer greater flexibility. Investors don't have to make a multi-year commitment and can shift to another fund if a scheme is underperforming. In a Ulip, the investor can only switch between funds offered by that Ulip. "ELSS funds have lost some of their sheen but they still remain the best option in the 80C basket for longterm wealth creation," adds Shah. Besides, ELSS still has the shortest lock-in period of three years among all instruments under 80C.
Avoid Ulips, insurance policies
After the Budget announced the tax on LTCG, insurance companies have started highlighting the tax-free returns from insurance policies and Ulips. However, financial planners advise against investing in these plans. "We recommend investment products that give taxable returns but perform better than products that are tax free but give low returns. Mutual funds remain our first choice,," says Abhinav Angirish, MD, Abchlor Investment Advisors. In any case, insurance and investments should not be combined in a product. A term plan serves the objective of protection and MFs generate higher returns.
If you want to save tax under Sec 80C, a combination of ELSS and PPF is perhaps the best option. While ELSS generate higher returns, PPF provide a stable foundation with assured income. "Ideally, investors should have a mix of ELSS and PPF. This fetches the investor three benefits under one basket-asset allocation afforded by mix of equity and debt, safety of a government-backed vehicle and pure growth of an equity offering," says Joshi.
Arbitrage for short-term
Equity arbitrage funds, a sub-category that offers 'debt like return and equity like taxation benefits', have also been hit by the new tax. Returns from equity arbitrage funds are comparable with those of short-and ultra-short term debt funds. Investors would park their shortterm funds in these funds to gain from the tax advantage. While debt fund investors were forced to pay a dividend distribution tax (DDT) of 28%, there was no DDT here. Similarly LTCG were tax-free after a year of holding. Debt fund investors paid 20% tax even after holding for three years.
Though equity funds will now be subjected to LTCG tax and DDT, experts say arbitrage funds are still the best option for short-term funds. Equity arbitrage funds continue to generate better post-tax returns than other alternatives. The tax rate is also still attractive. While debt funds investors pay a total DDT of 29.12% after 1 April, it is 10.4% for equity arbitrage funds. Similarly, the tax advantage is huge for 1-3 years holding period.
The increase in stock market volatility is good news for arbitrage funds. The arbitrage opportunity is greater during periods of increased volatility. However, the same may come down if the correction continues for very long.
In arbitrage funds, the dividend option makes more sense. The tax rate on short-term capital gains is 15%, while dividends will be taxed at 10%.
Arbitrage funds make money by buying and selling in different market simultaneously to corner the price difference. Their risk profile is comparable to that of debt funds. However, these funds can be very volatile in the short term. The ideal investment horizon for this segment is 6-12 months.
Time to buy debt funds
Retail investors in mutual funds often ignore debt funds. One reason is the tax treatment of returns. Short-term gains from debt funds are added to your income and taxed at normal rates and long-term gains are taxed at 20% after indexation. Though equity funds still retain the upper hand (minimum holding period for LTCG is one year compared with three for debt schemes), the 10% tax on LTCG from equity funds has reduced the tax disparity. Gains from debt funds are eligible for indexation benefit which makes these schemes fairly tax-efficient. Indexation can significantly reduce the effective capital gains, reducing the tax liability for the investor.
Experts say investors should integrate bond funds in their portfolio and use them in conjunction with equity funds for goal planning.