Cost of Investments
We love taxes…
… said no one ever!
When you invest and make a profit from them, that profit is considered taxable.But, there are a few nuances. Let’s see what they are.
Capital Gains
Capital gains refer to any profit or return you make from your investments. They can be either short term, or long term. The amount of tax you need to pay depends on two things:
(1) Type of investment
(2) Duration of investment
Gains from anything held for over 3 years are considered long term.
Side note: For non-movable investments, such as land, or a house - the cutoff is 2 years, and not 3 years. Equity oriented investments such as equity mutual funds, or stocks - anything under 1 year is considered short term, and over 1 year is considered long term.
How much tax?
For short term (<1 year) equity oriented investments, the tax rate is 15% for capital gains. For long term (>1 year), the tax is 10% if gains are greater than 1 Lakh in that financial year.
You may hear the term “indexation” when it comes to calculating your capital gains. It’s just another fancy word for factoring in inflation while determining how much gain you actually made.
Non equity investments
Slightly different rules here. Gains for these investments made for 3 years or less are taxed at your tax slab rate. For more than 3 years, tax rate is 20% post indexation (i.e., factoring in inflation over the period).
Dividends
In some cases, you get paid a dividend as part of your investments. Very simply, there is a separate tax associated with these dividends.
Tax Saving Investments
80C, your new best friend:
Section 80C of the income tax act offers several tax benefits. This is very useful to know, so let’s see what those are!
Under 80C, there is a sizable amount you can deduct from your income every year. A deduction is nothing but an amount of money that can be removed from your total taxable income.
Maximum limit under 80c
Upto 1.5 lakhs a year can be deducted from your taxable income under the 80C rules.
What counts under 80C
There are a number of options to benefit from 80C. These include Public Provident Fund (PPF), NSC (National Savings Certificate), EPF (Employee Provident Fund), Tax saving fixed deposits, NPS (National Pension Scheme), ULIP (Unit Linked Insurance Plans).
A great way to leverage 80C benefits is to invest in ELSS mutual funds. ELSS are equity linked savings schemes, a special type of mutual fund. They come with a lock in period, and have delivered good returns.
A year in the life of…
It’s April 2019 - let’s meet Asha. She works at a technology company and has taxable income of around ₹6,00,000 per annum.
Her income to the extent of ₹2,50,000 is tax free (Taxable income ₹3,50,000)
If Asha invested ₹50,000 another in ELSS mutual funds, she could be saving an additional ₹2,500 more on taxes. Let’s see how that will play out.
Her Net Taxable income(after 80C deductions of 1.5 lakh) = ₹ 3,50,000 - ₹ 1,50,000
Total tax(5%) = 5% of ₹ 2,00,000
Her total tax savings = ₹ 10,000
She makes an additional saving of ₹ 2,500 in taxes by increasing investments under Section 80 (C). This means the tax she has to now pay is ₹ 5,000 only. Apart from the tax investment she also gains in returns for the amount she would continue to invest.
Capital Gains
Determining capital gains is not straightforward, and so Asha approaches her investment platform or an RTA like Karvy or CAMS (RTAs manage back office operations for mutual fund houses) and receives a capital gains report.
Returns filed, tax saved
Based on her capital gains report, Asha is able to work with her tax adviser to file taxes appropriately for gains on her investments. Her EPF and PPF will save her some taxes - and her new ELSS investments will add some more!
Earn more, invest more
At her current salary her tax savings are ₹5,000 with EPF and PPF investments. With ELSS mutual fund investment of ₹50,000 her tax savings will be ₹7,500.
As her earnings increase so will her taxes. But if she chooses wisely to invest in tax saving schemes she will save more!
Fees in the Mix
There’s no such thing as a free lunch, they say. Similarly, with investments, your profit is not just output amount minus input amount. There are intermediaries, or agents that help you create and withdraw your investments. These entities will charge you for the services they offer. Since fees eat into your returns, it’s important to understand what they are.
Broadly, there are two categories of fees:
Transaction fees: These are one time fees you pay when you enter into or exit out of an investment
For stocks, you may pay a commission when you buy or sell a stock to the intermediary (a stock broker) who does the transaction for you.
For mutual funds, be mindful of Transaction fees (Charges when you buy into a mutual fund if you use a distributor/agent) and Exit Load (Fees paid when you withdraw your investment).
Ongoing Fees: We mentioned TER, or Total Expense Ratio, in a prior lesson. This is super critical. Let’s see why.
Total Expense Ratio is a percentage of the average value of your investments that you will be charged every year by the fund house that is managing the mutual fund.
SEBI, the securities regulator, has capped these expense ratios at 2.5% for equity funds and 2.25% for debt funds.
TER directly eats into your returns, but it’s the fee you are paying the fund house to manage your money.
Typically, larger mutual fund houses that manage large amounts of money have lower TER.
Other fees
Advisory fees: if someone is advising you to invest in certain products, they may charge you an ongoing annual fee that is also typically a percentage of your total investments. Finally, there may be other fees you have to pay for things such as early withdrawal from an investment. When in doubt about how much you are paying as fees, always ask.
To summarize, there is a cost to making investments. Having transparency around what and how much you are paying is important to understand. Your returns are directly impacted by these fees.
