This article settles the question of which type of capital gain calculation is better - debt-type funds taxed at 20% with indexation vs equity-type at 10%.
Disclaimer: Taxation is a dynamic concept and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.
Capital gains are the profit from selling a capital asset like stocks or mutual funds. Capital gains are of two types depending on the holding period (see table A below):
While talking about the LTCG for mutual funds, an interesting problem arises (see table A below):
We will examine over the long term (i.e. 3 years or more), which leads to lower taxation. While we might be tempted to say that the 10% case has a lower tax, the indexation benefit of debt-type funds might lead to a different result even with a 20% tax rate.
Should you invest in international stocks and funds if they are taxed at higher rates?
The question comes from the fact that, apart from debt funds, international funds also have the same debt-type taxation rules.
Table A: Taxation of stocks and mutual funds
| Type | Portfolio | Short-term capital gains | Taxation | Long-term capital gains | Taxation |
|---|---|---|---|
| Shares, Equity MF or equity-oriented Hybrid MF | >65% Indian equity | <365 days | 15% + cess + surcharge | >= 365 days | <1 lakh/year is tax free. Gains above 1 lakh are taxed at 10% + cess + surcharge |
| Debt or Hybrid funds (debt oriented) or International funds | <65% Indian equity | <3 years | Taxed at slab rate | >=3 years | 20% + cess + surcharge on gains post indexation |
where, Capital gains = (Selling price - Buying price) * Units sold
and
buying price post indexation = (Buying price) * (Cost Inflation index today / (Cost Inflation index at the time of purchase). We cover this calculation in considerable detail here: How to use the Cost Inflation index (CII): latest value and historical rates.
Note that for equity shares and equity mutual funds, any capital gains incurred before 31-Jan-2018 is not taxable. This is the so-called ‘grandfathering clause’.
We will ignore the impact of the ₹1 lakh tax benefit for equity LTCG by assuming that there are already other sell transactions that use up this benefit.
This post targets those decision-making cases where investors might be choosing an equity-type fund vs. a debt-type fund, which are similar in the portfolio but differ in taxation.
Recent articles:
To understand the difference between the two taxation rates, we need to understand one fundamental point:
Indexation = Return - Inflation
If your asset grows at an average of 10% while inflation is 7%, then the taxable return is 3% per year.
The formulas are:
Equity-type taxation = 10% * [ (1+Return) ^ Time - 1 ]
Debt-type taxation = 20% * [ (1+Return) ^ Time/(1+CII) ^ Time - 1 ]
After ten years, the tax will be:
If we run the numbers,
On a ₹1 lakh investment, the maturity values will be:
We will now show sensitivities for this result for a ten-year holding period:
As the table shows, the gap at 7% inflation and 10% returns is ₹9,567 as calculated above.
We show a different type of sensitivity table for real returns (fund returns less CII) vs. the holding period. This is important since real returns over long-term holding periods are expected to be very close to zero.
As the table unambiguously shows, for longer-term holding periods at a portfolio level, it is better to have a 20% tax with indexation as the tax rule.
A caveat that applies here is that tax rules are dynamic and will change without warning. While taxation is an important criterion for choosing assets, it should be considered with other aspects like risk, return and liquidity. The most important criterion for planning for goals is the asset allocation of the portfolio and should be the first criterion when creating a portfolio: What should be the Asset Allocation for your goals?.
As India matures as an economy, both inflation and equity or debt returns will go down over time meaning that the relationship between real portfolio returns will stay the same.
If you liked this article, consider subscribing to new posts by email by filling out the form below.This article shows how a young just-married couple can invest for future goals using the Arthgyaan goal-based investing tool.
Did you welcome a bundle of joy in your 40s? This article will discuss ways of planning the child’s (and your’s financial future)
This article shows how a very typical salaried couple with one child can invest for future goals using the Arthgyaan goal-based investing tool.
This article shows that if you decide to retire today, how long will the corpus last realistically based on real rates of return.
Published: 18 September 2022
9 MIN READ
We discuss if it is a good idea for conservative NRI investors to create a retirement portfolio in India only with safe and risk-free investment options.
Published: 25 September 2022
8 MIN READ
This article explains why it is a waste of money to buy a term insurance policy beyond the usual retirement age of 60.
Published: 25 January 2023
5 MIN READ
This article shows the report card for the Indian stock market for 2022 vs the last 25 years.
Published: 22 January 2023
2 MIN READ
1. Email me with any questions.
2. Use our goal-based investing template to prepare a financial plan for yourselfDon't forget to share this article on WhatsApp or Twitter or post this to Facebook.
Discuss this post with us via Facebook or get regular bite-sized updates on Twitter.
More posts...Disclaimer: Content on this site is for educational purpose only and is not financial advice. Nothing on this site should be construed as an offer or recommendation to buy/sell any financial product or service. Please consult a registered investment advisor before making any investments.
This post titled Which mutual fund has lower tax - international funds at 20 percent vs domestic at 10 percent? first appeared on 21 Sep 2022 at https://arthgyaan.com
