Aditya Birla Sun Life Mutual Fund

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Should you churn your equity mutual funds portfolio to save on long term capital gains tax?

Mar 26, 2018
5 mins | Views 179

Ajay is a young, middle class working executive. He cares for his small family, wife and a daughter, and has been investing diligently towards his goals.

In fact, he invests Rs. 1 lakh in equity mutual funds on January 1stevery year. He has been doing this for the last 10 years. His portfolio has witnessed lots of ups and downs but finally he feels he has reached a respectable figure. 

However, the Long Term Capital Gain (LTCG) tax has him worried. He asked his colleagues what they planned to do.

One of them suggested churning the portfolio every year. That is to sell on March 31, 2019 and then buy back the investments again on April 1, 2019.  The sell amount is to be limited to take the benefit of Rs. 1 lakh exemption on the capital gains.

Ajay thought this to be a cool idea. That day in the evening he told his wife, Anu, about this wonderful solution.

She wasn’t sure if she understood it all but she made a comment, which got Ajay thinking.

“How much will you be able to save because of this? Is the effort worth it?”

This got Ajay thinking. He was sure that there is some benefit but didn’t know how much.

Next day he met another colleague, Suresh, in office and the topic of LTCG tax came up.

Suresh told him that while it sounds attractive to churn the portfolio and use the capital gains benefit to reduce tax, there are scenarios in which this effort may lead to no or insiginficant gains.

He sat down with Ajay to show him one such scenario. He first asked questions.

Q 1. How much do you invest?
Ans. Rs. 1 lakh at the beginning of every year.

Q 2. What is the returns assumptionyou want to take?
Ans. May be 15% per year.

Q 3. What is the LTCG tax rate?
Ans.  (i) Upto Rs. 1 lakh – NIL
        (ii) 10% + cess, thereafter. Total 10.4%

Suresh said that the returns assumption is not correct.

Market returns don’t occur in a straight line.There is a lot of volatility, ups and downs, in value. He simply can’t assume 15% every year.

So, he pulled out actual yearly returns data of one of the mutual fund schemes that Ajay had been investing in since 2008.

This is how the input numbers looked now.

Year

Return (%)

Start of the year - Buy NAV / Price

End of the year NAV

Yearly Investment

1

-58.36

100.0000

41.6400

1,00,000

2

87.28

41.6400

77.9834

1,00,000

3

14.46

77.9834

89.2598

1,00,000

4

-28.04

89.2598

64.2313

1,00,000

5

29.81

64.2313

83.3787

1,00,000

6

7.23

83.3787

89.4070

1,00,000

7

60.14

89.4070

143.1764

1,00,000

8

4.77

143.1764

150.0059

1,00,000

9

8.48

150.0059

162.7264

1,00,000

10

41.85

162.7264

230.8273

1,00,000

Source:  https://www.valueresearchonline.com/

Now there are 2 scenarios to be taken into account.

In Scenario 1, you do not churn the portfolio and don’t take benefit of Rs. 1 lakh annual capital gain exemption.

In Scenario 2, you churn the portfolio in a way that you get to take the benefit of Rs. 1 lakh annual capital gains exemption.

 

 

 

Scenario 1

Scenario 2

Difference

Final portfolio value (after tax)(INR)

25,25,625

26,18,407

92,782

CAGR

 

 

19.4%

20.2%

0.7%

When we work this out, in Scenario 1, after 10 years, yourfinal post tax value will be Rs. 25.25 lakhs. This is a CAGR of 19.4%.

While in scenario 2, after 10 years, your final post tax value will be Rs. 26.18 lakhs with a CAGR of 20.2%.

The difference in CAGR is 0.7%.

“Now that might look good on paper, but how much will you be able to realise in a real portfolio cannot be forecasted now”, Suresh told Ajay.

“Further there areadditional costs related to accounting and tax filing. Not to mention, all the effort involved.

And the big question - you are better off saving and investing more than getting into this tax jugglery.

Use your time to be with your family.” Suresh spoke.

Ajay nodded in agreement.

That evening Ajay spoke to his wife and told him that he is not going to bother spending time making tax adjustments.

Anu was glad and said, “Isn’t keeping things simple the whole point of investing in mutual funds to keep things simple?”

Ajay smiled. He planned to keep things simple.

 

So, this was Ajay’s story. What about you?

If you are a small investorin mutual funds, it is important for you to focus on your goals, asset allocation and invest regularly.

Ideally, withdraw your money when you need it for the specific goal you are saving for.

Churning the portfolio only to reduce tax can create a lot of churn in your mind too. Not just that, in case of few mutual fund schemes you may have to take into account exit loads and lock in period too. The additional benefit of saving some tax could demand a lot more effort. At the end of it, you may not get the desired result as well.

Keep your investing simple. Mutual funds allow you to do that.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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