Tax changes in mutual funds: How to manage your investments now

Changes in tax rules at the end of a financial year is not something that you routinely expect. And not when it is a sweeping change on taxation in your mutual fund! In this article, we are going to discuss the recent tax changes in mutual funds in 4 parts:

• One, the changes effective April 1, 2023 and the categories impacted
• The tax impact for you and what you can do to plan better
• What should you do with your existing investments?
• How should you plan your fresh investments?

What is changing with mutual fund taxation?

The Government has decided to remove the long-term capital asset benefit for some mutual fund categories. They are:

• All debt mutual funds including target maturity/index debt funds and ETFs
• All gold funds and ETFs
• All international funds
• All conservative hybrid funds in their current form
• All Fund of funds, except those that invest only in equity ETFs
• Any other fund category/scheme with exposure of less than 35% in domestic equity.

What the change is: There will be no distinction between long term and short-term holding period for the above categories of funds. The gain from these funds will be added to your total income and taxed at your income tax slab rate. This new law is applicable for investments made after April 1, 2023. 

What the impact is: The impact of this tax change, for investments in the categories mentioned above, is as follows:

• Nothing changes for existing investments and investments made before March 31, 2023. Their taxation remains the same as it is now, whenever you sell them. That means, holding more than 3 years qualifies as long term capital gains (LTCG) and you will get indexation benefits with a tax rate of 20%. There is thus no impact for any investment made.
• Nothing – in practice – changes for future investments where your planned investment timeframe is less than 3 years. You do not enjoy LTCG benefit for less than 3 years holding at present and you will not have it from April 1, 2023 either. 
• For investments made from April 1^st 2023 and onwards, your tax incidence will go up on investments in any of the categories mentioned above.  For these investments, even if your holding period is over 3 years, you will get no indexation benefits.

The taxman has not altered the other categories of funds. They would be as follows: 

• Where the equity allocation is between 35-65% – for any category of funds, the existing tax rules on will continue to apply. That is, short-term capital gains on holding period of less than 3 years will be taxed at your slab rate, and beyond will be taxed at 20% with indexation. The categories that fall into this set are primarily the hybrid – multi asset category. Some solution-oriented funds also fall into this bucket. Another category called balanced funds (there are no funds under this now) will also retain this taxation status if new funds are launched in this space.
• Where the equity allocation is above 65% – here too, tax rules haven’t changed. Long term is holding for greater than 1 year, and capital gains here are taxed at 10% with the first Rs 100,000 of gain being tax-exempt. Short term capital gains are taxed at 15%.

Tax changes in mutual funds – outgo and management

The indexation benefit was lowering your tax outgo by increasing the cost of your investment, bringing it to inflation-adjusted value. That benefit is now gone. Additionally, the tax rate was set at 20%, regardless of your slab rate.

Now, the biggest fear of additional tax outgo comes from the fact that the capital gain (sale value less original cost) will be added to your total income and taxed at your slab rate. The impact of this can be quite low or very high depending on whether the capital gain is going to push you to the next slab rate or retain you in the same slab (discussed further down). 

First, let’s take up the additional tax outgo owing to the new tax rule. 

When you read in media reports that if you are in the 30% tax bracket, this capital gain too will be taxed at 30%, it seems like a lot of cash outgo! But in reality, it is not. 

The reason why it is mentioned so is simply because, in India, we are currently paying taxes on a marginal tax rate basis. The 30% tax rate for example, is for the additional rupee you earn after your income crosses a certain threshold. Your entire income is NOT taxed at 30%.

So, if you want to know your real outgo, be cognisant of the average tax you pay on your total income.  For example, if your total taxable income is Rs 12 lakh, your tax under the old regime is Rs 1,63,800. That brings your average tax rate (total tax divided by total taxable income) to 14.9%, although you fall under the highest tax slab of 30%. Therefore, understand that the additional tax outgo will not be always high unless your capital gain pushes you to the next slab level. 

Let us explain this with a simplified example. Assume the following:

• Your total salary income after all deductions is Rs 9,50,000. 
• You invest Rs 100,000 in a debt fund on April 1, 2023 and you sell it after 3 years. The debt fund returns 7.5% annually, bringing the sale value to Rs 124,230.
• The cost inflation index is 6%. 

The LTCG with the indexation benefit works out to Rs 5,128. 

Without indexation (the latest change) the taxable LTCG is Rs 24, 230 which will be added to your income of Rs 9,50,000 under the old tax regime.

The tax incidence in the two cases would be as follows:

As you can see, the additional tax outgo for you due to removal of LTCG, compared with the old rule, will be Rs 3973 or 4% more. That is not an alarming increase!

The tax impact is heavy when the capital gain pushes you to a higher tax bracket. Continuing with the above example – assume the taxable income, returns & cost inflation index remains the same, but with the debt funds investment is Rs 10 lakh instead of Rs 1 lakh. Here, the numbers stack up as follows: 

In the above case, where you jump slabs (greater than Rs 10 lakh), the additional tax outgo from the new rule is Rs 27,391 or a whopping 23% higher outflow! 

Please note that these are merely illustrations. The quantum of your gain and the cost inflation indexation you will actually lose will all change the picture of the additional tax impact. But it is safe to conclude that within the same tax slab, your outgo will not be too painful. If you jump to a new slab, the increase can be heavy. This is true whether you choose the new or old tax regime and there can be no pattern to which is better.

Given below is an excel sheet for you to check what will be your total tax outgo both under the old and new tax regime, if you sell you debt funds. We also show you the tax outgo if you don't sell them and hold them, so that you know the additional tax out go.  

Your strategy to ensure that your tax outflow does not hurt you much can broadly be as follows:

• You will need to plan your redemptions, especially for long-term goals, a bit more carefully to ensure your tax outgo is contained in a particular year. The dipstick test is to see if by adding your capital gain, you remain in the same slab or jump to the next slab. Phased redemptions will become necessary before major goals. 
• Tax harvesting, by periodically booking profits and re-entering again right away, may become necessary to ensure your gains are not too high that can push you to higher tax slabs. This is less of a necessity for those already in the highest tax slab and more applicable for those in the lower and middle slabs. Since you do not get the indexation benefit (which boosts your cost), the only other option is to exit and re-enter at a higher cost, thereby inflating the cost for tax purpose for yourself.  For example, if you invested at Rs 5 NAV and sold at Rs 7, you get taxed on Rs 2. And when you re-enter at Rs 7 immediately, the cost for tax purpose is Rs 7. So, you have inflated your cost for future tax calculation, although your original investment was at Rs 5. 

Second, let’s take up the debate on the parity in taxation of fixed deposits and debt funds and whether FDs make more sense now. From merely a tax perspective (and not on other counts), we don’t think FDs are better off for the following reasons:

1. With FDs, you lose tax every year, even when you hold a cumulative deposit as it is taxed on accrual. With mutual funds, you are taxed only on redemption. The time value of money, by delaying tax outflows, act in your favour. There is also no TDS with debt funds.
2. Although some of the categories of funds have lost their long-term status, they are still considered capital gains. Which means the short-term capital gain can be set off against any short-term capital loss. This is not a benefit available with FD interest.
3. Systematic withdrawal plan, even after the tax change, will remain beneficial because of the way it is taxed. For example, if you are deriving Rs 10,000 per month of interest income from your bank, the same is fully taxed. However, if you do a SWP of Rs 10,000 per month, then only the gain component is taxed. This could be very low in the initial years (higher principal) and slowly grow in later years. Even so, the entire withdrawal is not taxed. This gives SWP an advantage over interest income. Read more about how to use SWP here.

Besides the above tax reasons, the liquidity that debt funds provide is unmatched. Yes, like before, you can and should always look at FD options that offer attractive interest. We encourage you to use our Prime Deposits as part of your fixed income portfolio (discussed further in the next section). 

What should you do with your existing investments?

For the debt funds (or other funds that are impacted from the tax changes) that you are already invested in, continue holding. These investments do not come under the new rules and will continue to qualify for long-term capital gains and indexation benefits any time you redeem in the future. There is no action that you need to take for these.

If you have some amount to invest now and you want to take full advantage of the small window you have until the new rules kick in, you can invest this in debt funds that meet your requirements:

• Add to your existing debt funds that form part of your portfolio. Given that these will still enjoy lower taxation, it will come in handy at the time you need to redeem to meet your requirement. This would be the ideal step to take if you are approaching debt funds from a goal-based or portfolio perspective, or you have no specific timeframe in mind.
• Lock into target maturity funds that offer good yields, but only if you have a specific period in mind. Our recent article on this will be of help. While many of these funds are at attractive yields now, remember that at the time of maturity, the amount will be returned to you – you’ll have to reinvest it at that point if you do not have any expense to meet, and this reinvestment falls under the new tax rules. So, unless you have a clear requirement, stick to topping up your existing debt funds if you have a surplus now.

How to manage your fresh investments?

Before we discuss about where to invest in, we think you should avoid falling into pitfalls on poor investment decisions merely to save tax. In other words, tax should not be the primary driving factor for investments. Returns and safety must score first. Hence, let us first address the issue of what you should avoid, especially as agents and distributors are likely to sell you products that will appeal in terms of lower taxes. 

What to avoid

• Avoid making asset allocation decisions based on taxes. By that we mean, don’t load up your portfolio with equity-based funds just because debt fund gains suffer tax. As explained earlier, the additional tax outgo is not always prohibitive. Debt has a role to play in your portfolio, to balance the equity risk. By going all-equity, you will be upping the volatility and risk in your portfolio. Debt does not need to come from debt funds alone; see further below for more.

• Avoid loading up on hybrid funds. While hybrid funds are lower on equity risk, they are still equity based. They are not debt substitutes so do not consider them to be one in your portfolio. Even equity savings funds, which take the most hedging, deliver losses in 1-year periods more than 10% of the time. The average 3-year return for equity savings funds, rolled over 3 years, is at about 8.1%. While this is not a raw deal, it is important for you to know that even in the worst periods (like the last few years) gilt funds have delivered an average of 8.4% over the same period. Remember that interest rates have been low for the past few years and have weighed on debt fund returns while equity savings have been pulled up by high performance of equity. Hence when equity goes down, you cannot expect equity savings funds to provide the support that debt would. They can form part of shorter duration portfolios for their tax efficiency but there is a return penalty in the long term.

Balanced advantage funds manage higher returns averaging at 10.2% in the above period. But then, unhedged equity exposure, which drives returns, swings wildly between funds. Based on hedging strategy, they can be similar to aggressive hybrid funds with very high equity exposure. That again makes them poor debt substitutes. So, while you can increase allocation to these funds for the tax benefits, do not assume them to take over the role of debt in your portfolio. 

Arbitrage funds come the closest to debt in terms of low volatility and low risk, but returns here are very, very low. Arbitrage funds often return lesser than even liquid funds; it is only the equity taxation that make them favourable. So even if they do have short term usage due to their tax status, for longer periods, when compared against longer-term debt funds, returns even post tax at the highest rate would be above that of arbitrage funds. Overall, there is a high chance that you would be sold hybrid funds not fitting your risk profile or time frame. Please stay clear of such sales pitches. 

• Stay cautious with insurance products: Many of you have asked whether money back, endowment and guaranteed income plans from insurance would become more attractive. On the last part first, most guaranteed income plans were meant to be HNI products with premium above Rs 5 lakh. Whether they will remain in vogue in the coming years is in question (and even if they do, getting a small income stream from these, when premium is lower than Rs 5 lakh may not even help you much anyway) as the latest Finance Bill brought the proceeds under taxation. On money back and endowment, while there are claims of high returns, the few products on which we have responded by way of queries from some of you in the past suggest that returns remain low. Yes, a target maturity fund with a 7.75% yield may deliver a net 6.5% on an average for a 20% tax bracket (average rate of tax at 15%). But please don’t forget that active debt funds such as corporate bond, banking & PSU debt or even gilt can deliver significantly higher returns when rates fall and can help you lock into those gains as well, since you can exit anytime. Hence, study the details of such insurance products by way of cost, lock-in, transparency and returns before making the plunge. 

Yes, it is possible that debt-oriented ULIP products with low costs may start competing in this space given the better tax structure. If they are transparent, provide disclosure and information required to assess, and have low cost, we will be open to exploring them. 

What to continue

Needless to say, nothing changes with your fresh investment strategy in equity and equity-oriented funds. For the ones where there is a change, read the following below:

• Continue investing in international funds. These funds provide diversification in a portfolio and being equity, do have high return potential. The tax treatment alone is not reason enough to remove them from their portfolio. Low cost, passive US-based funds remain our choice. While direct stock investing through the LRS route is an option, given the tax collected at source on such remittance (at 20%), we think this route is not a desired one for a retail investor. 
• Continue investing in gold funds. Gold should remain part of your long-term portfolio for the simple purpose of providing hedge when equity does not do well.  While physical gold and SGBs will score on tax henceforth, we think the liquidity offered by gold funds will remain a key reason to stay invested. If you find SGBs with liquidity, you can explore them. 
• Continue with short-term debt funds for short term needs. With interest rates at a high, the short duration funds have seen a marked improvement in their yields. Short duration funds for example have seen their YTMs (yield to maturity) raise from 5.5% in April 2022 to 7.7% in February 2023. They may yet rise by a few basis points. If these are meant for your short-term needs, there is no need to give up on them. Yes, if you find fixed deposits for similar short tenures at such rates, there is no reason to shun them, if you don’t mind the tax on the interest accrued. 
• Active debt funds may have an edge. We have thus far recommended target maturity funds (TMFs) on a hold-to-maturity basis given the current high yield and indexation benefit available. With the latter ceasing from April 1, we do think that the ability of active debt funds to generate superior capital appreciation opportunities will have to be pitched against just the high YTMs of TMFs. To this extent, we would recommend continuing and adding more to high quality active debt funds, in line with your time frame requirement from Prime Funds. 

Where else to invest in 

1. Select NCDs and privately placed bonds: We do think that direct investing in bonds can be a way to supplement your debt fund investments (not replace them). With increasing avenues to invest in the listed debt space through various platforms, at PrimeInvestor, we will look at select opportunities to invest in these bonds. But please note that the interest pay-out on these remain taxable. Capital gains on such bonds are taxed as part of your income if sold within a year and are taxed as long-term capital gains at 10% (without indexation) if sold after a year. But please stay away from credit risk products in this space. The credit risk is worthwhile only if the return adequately compensates for it and such risk is still within investment grade for retail investors (AA-) or even HNIs (above BBB). At PrimeInvestor, while we have selectively given privately placed bond calls, we will look for opportunities with other bonds as well. 
2. Deposits with attractive rates: Since the change brought about in bank deposit insurance in August 2021, we have advocated that for those in the low and middle tax bracket, deposits with attractive rates, even in smaller banks have begun to make sense from a  risk-reward perspective. Towards this we changed our Prime Deposits list to include small finance banks and NBFCs. We also added a Prime FD tool to provide you our confidence level  on the quality of the banks you invest in. 
3. G-Secs/SDLs : For those of who can time entry and exit, investing in G-Secs is an option now that mutual funds will no longer offer superior tax benefit. For those looking to seek income, we have always advocated creating some income stream with SDLs and G-Secs and have recommended these over last year and earlier this year when the tenure and return were attractive. For both of these, it is best that you open a RBI Retail Direct account (with NDS-OM secondary market) online for free. 
4. NPS: If you are in the high tax bracket, both Gilt and Corporate allocations of the NPS become a viable option for your debt portfolio for long-term retirement. Three factors work on its favour: one, 60% of your corpus on redemption enjoys tax free status. Two, it allows you to ability to switch between options and fund managers without tax impact. Three, it is an extremely low cost product and expense ratio eats little into returns. Use our NPS fund Manager Ranking tool to choose your allocation and fund manager. 

At PrimeInvestor, we are future ready. We not only look at clean and transparent products from a risk-return perspective but think beyond taxes and look at newer, emerging low-cost products that can help build wealth in a sustained manner, whatever be the direction of taxation.