Regulatory risk is the risk that your investment portfolios could be affected because of a change in regulation. This week, we discuss the impact of the change in long- term capital gains (LTCG) tax on your goal-based investments.

Break-even rebalancing

All your goals, when initiated, will have a time horizon of more than one year. So, your goal-based equity investments will be considered long-term capital asset and the gains will attract LTCG tax. The 2024 Budget raised the annual exemption limit on LTCG from ₹1 lakh to ₹1.25 lakh but increased the tax rate from 10 per cent to 12.5 per cent. Therefore, the break-even LTCG is ₹2.25 lakh. That is, if your annual LTCG is ₹2.25 lakh, you will be indifferent between the revised tax rate and the old one. A higher LTCG will mean the revised rate will hurt you as taxes will be higher.

The question is: will your annual LTCG be greater than ₹2.25 lakh? To answer this question, you must consider how you rebalance portfolio. This is a process of taking profit and lowering your equity allocation to reduce the risk of losing unrealised gains on your investment. Your rebalancing rule is based on the expected and actual return on your investments.

Suppose you expect your equity investments to generate 12 per cent annually. If the actual annual return is 14 per cent, you must take profit to the extent of two percentage points (14 per cent less 12 per cent). You must allow the 12 per cent unrealised gains to compound inside the portfolio. It is on the excess return you pay LTCG. This rebalancing cash flow must be lower than ₹2.25 lakh. Otherwise, the revised tax rate will hurt your goal because your post-tax returns will be lower than what you assumed when you started the investment. If your equity investments exceed ₹1.125 crore (₹2.25 lakh divided by 2 per cent) and you rebalance your investments annually, then the revised LTCG rate will have an adverse effect on your post-tax cash flows.

This assumes you will rebalance if the annual unrealised gains are at least two percentage points above the expected return.

Conclusion

The change in Income Tax regulations can impact post-tax cash flows when you rebalance and when you finally sell your investments at the end of the time horizon for a life goal. You may have to bridge the shortfall if such changes have an adverse impact on your investments.

(The author offers training programmes for individuals to manage their personal investments)

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