With a lot of heat and dust about the LTCG taxation on equities one aspect of it, namely, the real impact of the tax on an investor’s long term return have largely got very little attention. I was made aware of it through an article by Dhirendra Kumar of Value Research Online and largely agree with what he has said. As many of the investors may have missed out on this, let me try and explain it in this post.
Now, we all know that it is possible for equity to grow at a rate of 12-15 % in a long term period of 10 years and more. Of course, the growth in equity is non-linear, meaning you may well grow 30 % in a year like 2017 and even have negative growth as in 2008 and 2011 etc. If we look deeper into the growth of our MF investments we will see there are clearly 2 parts to it – first is the inflation prevalent in the economy and the second is the real return you get on your investment. For example, if your MF investments have grown by 15 % and inflation during this period was 8 % then your real return is 7 %. In general, your real return can exceed 10 % in a good year for the markets and will be in the range of 4-8 % in other years. Again, if the markets turn negative or are mostly sideways in a year then your real returns may well be negative.
With this backdrop, we will take an example to understand the impact of the recently introduced LTCG tax on equities on your MF returns:
- An investor starts investing through SIP in one of the popular MF schemes from April 1st 2018. Let us say the amount is 20000 and he wants to do it for 15 years.
- At 12 % annual returns he will get about 1 crore, which he plans to use for his daughter’s higher education.
- His overall LTCG will be to the tune of 64 lacs and the tax thereon will be 6.4 lacs.
- Now if we assume that the inflation component is 6 % and the real returns are also 6 % then the real returns are to the tune of 32 lacs.
- In effect you are paying 6.4 lacs tax on a 32 lac real gain – this comes to 20 % and not 10 % as most of us are given to understand.
- This situation could have been corrected if indexation was allowed but that has not been done in the case of LTCG on equities.
- The 1 lac exemption etc has very little meaning for people looking at a large goal as it will be an insignificant part as compared to the goal amount.
- In simple terms you are being taxed on inflation too, which is grossly unfair !!
In terms of the goal itself, you will need to increase your monthly SIP amount by 1281 Rs so that you are having the required goal amount after taxation.
So what can you do from your end to see that you minimise the taxes at least? Well, for one, you can spread the redeeming over the years of college so that the impact will be shared over 4 years or so. This will not affect the total tax outgo but you will feel better that your tax payment at one time does not appear so horrendous.
I hope the intelligent readers would have understood the real dangers here. Even if your real return is much lower, say 10 % you still pay a lot of tax. For the above example at 10 % returns your LTCG is 47 lacs and you pay tax of 4.7 lacs. As a percentage of real return you are now talking of well over 30 %. If your real returns are even lower if the market tanks in that year, then the tax paid as a percentage will be even higher.
The conclusion is a simple one – by not allowing for indexation the FM has really dealt a body blow to long term investors who have been investing seriously over the last several years and have played a stellar role in the success of our stock markets.
What strategies can you adopt for your investments? I will take this up in another post.