HOW TO CALCULATE LONG TERM CAPITAL GAIN (LTCG) TAX ON MUTUAL FUNDS?

When you talk about long term capital gains tax on mutual funds you talk about debt and equity separately. However, when it comes to equity funds, there are two phases of LTCG calculation. There is pre-2018 budget and post-2018 budget. That is because, it was only in the Union Budget 2018 that the long term capital gains tax on equity mutual funds was made taxable for the first time in the hands of the investor. We will see that in much greater detail, but let us understand about long term capital gains on debt funds first.

HOW IS LONG TERM CAPITAL GAINS ON DEBT FUNDS CALCULATED?

For tax purposes, any mutual fund is only classified into two categories viz. equity funds and non-equity funds. So, all the debt funds, liquid funds, money market funds, gold funds will all be classified as non-equity funds and taxed on a similar model. Here is the model.

  • The first step is to classify the gains on the debt fund as short term and long term. If held for less than 3 years, the debt fund gains are short term gain. In that case, the total gains will be added to your total income and taxed at your regular incremental rate of tax. If you are in the 30% bracket, you get taxed at 30%, and so on.

  • If the debt funds are held for more than 3 years, then it will be treated as long term capital gains and subjected to concessional rate of tax. The rate of tax is 20% of the total gains. However, this tax is levied on the indexed capital gains.

  • For indexed capital gains, you can refer to the index numbers for each fiscal year put out by the Income Tax Act each year. If you bought a debt fund at NAV of Rs.100 in Jan-18 and sold it for Rs.142 in Jan-22, then you have held for more than 3 years. The IT index number for FY2017-18 is 272 and for FY21-22 the index number is 317.

  • First you calculate the indexed cost of acquisition as Rs.100 X (317/272) i.e. Rs.117. Now your indexed gains will be Rs.25 (142-117) and you will pay tax at 20% of Rs.25 or Rs.5. Effectively, your tax rate is not 20% but just 11.9% because of indexation. That is how indexing is beneficial in debt funds.

CHANGES TO LTCG ON EQUITY FUNDS IN BUDGET 2018

In the Union Budget 2018, the Finance Minister had announced a flat 10% tax on long term capital gains on all equity and equity mutual fund investments. This was a major shift because till March 2018, there was no long term capital gains tax on equities and equity funds. There were fully tax-free in the hands of the investor. Interestingly, a lot of people rely on equity funds to create wealth and meet long term goals like retirement, child education etc.

HOW IS LTCG TAX IMPOSED ON EQUITY FUNDS AFTER MARCH 2018?

When it comes to equity funds, the definition of long term capital gains implies a holding period of more than 1 year. However, this is a flat tax and so unlike in debt funds, there is no indexation benefit available. For example, even if you sell shares after 15 years holding, the tax will be imposed at a flat rate of 10% on the capital gains.

However, in lieu of the indexation benefit, there is one benefit of a basic exemption of Rs.1 lakh and any capital gains above Rs.1 lakh only will be taxable at 10%. This is the annual exemption limit. This gives the leeway to investors to plan their withdrawals in such a way that they can claim the exemption in as many years as possible.

HOW MUCH WILL THE LTCG TAX ON EQUITY FUNDS REDUCE MY CORPUS?

Obviously, when you pay tax on long term capital gains at the time of redemption, your net post-tax redemption value will be lower. Now if you have a 20 year fund, you don’t know what will be the capital gains tax rules at that point. However, you know that if the same rule is valid, then this is what happens to your profit under two scenarios.

LTCG Tax – Pre 2018 Amount LTCG Tax – Pre 2018 Amount
Retirement SIP monthly Rs.10,000 Retirement SIP monthly Rs.10,000
Tenure of SIP 25 years Tenure of SIP 25 years
Invested in Equity Funds Invested in Equity Funds
CAGR returns 14% CAGR returns 14%
Amount Contributed Rs.30,00,000 Amount Contributed Rs.30,00,000
Final Corpus Rs.2,72,72,777 Final Corpus Rs.2,72,72,777
Long Term Capital Gain Rs.2,42,72,777 Long Term Capital Gain Rs.2,42,72,777
Basic Exemption Not Applicable Basic Exemption Rs.1,00,000
Taxable LTCG Not Applicable Taxable LTCG Rs.2,41,72,777
Tax on LTCG Nil Tax on LTCG at 10% Rs.24,17,278
Net Corpus on hand Rs.2,72,72,777 Net Corpus on hand Rs.2,48,55,499

As can be seen from the above table, the final corpus in the post LTCG scenario is lower by over Rs.24 lakh. In this case, the exemption of Rs.1 lakh is very small when we consider the massive capital gains that will result in equities over a period of time.

This gets more pronounced in this case as there is no indexation benefit available to the equity mutual fund investor. Effectively, if the investor had a corpus of Rs.2.72 crore in mind, then it is essential to reduce that figure down to Rs.2.48 crore in the new tax regime. Your regular income will be received on this lower corpus after retirement and hence you need to adapt accordingly.

How much difference will this reduced corpus make in terms of regular income. Assuming that you were to deposit this corpus in a liquid fund earning 6% per annum, your monthly inflow post retirement will reduce from Rs.1,36,364 to Rs.1,24,2777 as a result of the impact of the tax on long term gains.

HOW TO PREPARE AND CHANGE YOUR PLAN FOR THIS LTCG TAX ON EQUITY FUNDS?

Here is what you can do. IN fact, you have two options in front of you. If you are not comfortable with a reduced corpus for retirement, the option is to increase your corpus contribution accordingly. If you have just started your SIP in the last 3-5 years then the thumb rule is to increase your monthly contribution to the SIP by 10%. That means; you can increase your monthly SIP from Rs.10,000 per month to Rs.11,000 per month to ensure that your final corpus is not impacted.

The question is whether you can really afford the higher outlay. However, that is the best way to hedge your bets in a situation where LTCG tax takes away a chunk of your long term wealth. You need to cushion that gap effectively.

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