The inevitable just became more so…
This was first published on beasquirrel.com on Mar 3, 2020
Yep, taxes, that’s the one. Over the last few years the taxman has systematically removed all the tax exemptions that used to accrue to mutual fund investments.
All the more reason to invest based on returns, safety and liquidity rather than for tax-saving reasons.
We’ve spoken with the fund houses, they’ve crunched the numbers and pored over the fine print and we’ve now assimilated the current thinking on all of this and our thoughts are in this blog entry.
Statutory warning: if your eyes start to glaze over while reading what follows, get up, wash your eyes and continue reading. This is important.
TL;DR:
Mutual funds are now subject to more taxability, more paperwork, more compliance.
Mutual funds continue to offer the best flexibility, convenience, safety, liquidity and returns.
Read on for more…
Background:
Equity gains used to be tax exempt. They became taxable a couple of years ago (debt gains have always been taxable).
Dividends used to be tax-free (in a fashion). Then, equity dividends were made taxable but only if you earned more than Rs.10 lakhs in a financial year.
Now, debt dividends too are taxable and what’s more is that MFs have to deduct tax at source (TDS) before paying out or reinvesting the dividend (both equity and debt).
So, what does all this mean for all of us Squirrels?
Primarily, dividends from debt schemes…
Until 31 March 2020, MFs pay/paid a dividend distribution tax of 20+ % before paying you the dividend. So, the dividend returns that you saw in your liquid funds was actually about 20% higher. Now, the dividend distribution tax has been removed, but now there’s a TDS of 10% instead.
This means that, assuming the funds continue to perform at the same level as hitherto, the dividend returns will be about 10% higher. So, if your investments earned, say 6% post distribution tax, they will now be about 6.75% because the distribution tax (20%) has been removed and replaced with TDS (10%).
This will mean higher returns in your portfolio.
But, here are the two significant downsides:
Number one, all the dividends are taxable, so you have to include them in your tax returns and if your tax bracket is higher than 10% (it probably is), pay the balance tax due (i.e., minus the TDS already paid on your behalf).
Number two, all this means more paperwork for you and your accountant: TDS certificates, reconciliation with tax department records, dividends statements, more headaches in your tax returns.
So, how do you avoid these downsides?
Strictly speaking, you can only postpone them. Stop investing in dividend options and invest only in growth options. That way, there is no taxable income until you redeem and there is no TDS (so far) when you do redeem. Of course, when you do redeem, any capital gains are taxable as usual (with some protection for long term gains and none for short term gains).
Secondarily, liquid funds…
These investments used to be pretty nearly tax free if you invested in a daily dividend option. That is no longer true. They are now just as taxable as any other scheme.
But they do continue to offer better returns than bank deposits, better flexibility and super liquidity. So, you should continue to park your surplus money in them. Choose the growth option to postpone taxability and avoid TDS (but not tax).
Many of you also use liquid funds for STPs (systematic transfer plans to transfer a lump sum to equity over a year or more). So, should you keep this sum in a dividend option liquid or a growth option liquid? Honestly, it’s six of one, half a dozen of the other.
If you stick with dividend, the dividends are taxable; if you use growth, the gains on each installment that is redeemed from liquid (and then invested in equity) are taxable. The growth option postpones taxability somewhat and avoids TDS (but not tax).
For new STPs we will probably choose the growth option, primarily because it will be a bit less of a hassle on the tax front. For existing STPs, if changing to the growth option isn’t too much of a hassle, we will do that, else stick with the dividend option.
We will reach out to those of you who are impacted and discuss this individually.
That’s all for now. Until the taxman clobbers us on the head again.
