Most of our income and expenses are subject to tax. It is useful to be aware in what manner and at what rate your investment returns are taxable. People look for tax efficiency. It improves your net-of-tax take-home returns.
However, you should not make tax efficiency the basis of your investment decisions. The reason is, if that be the basis of your decisions, then you are deviating from what is suitable for you. The criteria should be your investment objectives, cash flow requirements, investment horizon, risk appetite, and what is appropriate for your requirements.
Bank deposits
The most basic form of investments is bank deposits. The interest on deposits is taxable under the head ‘income from other sources’ at your marginal slab rate. If you are in the higher tax bracket, then this income is taxable at 30%, plus surcharge and cess as applicable. If you are in a lower tax bracket, then tax is accordingly lower. If your interest on deposits in one bank is more than ₹40,000 in a financial year, then there is tax deducted at source (TDS).
The TDS rate is 10%, and you have to pay the balance tax, as per your slab. The information about the TDS will reflect in what was Form 26AS earlier, now annual information statement (AIS).
Also read: Factor in foreign exchange risk while investing
Mutual funds
Mutual funds are a popular investment vehicle for many people. Taxation of MFs depends on the option you have chosen. There is a dividend option, now known as income distribution-cum-capital withdrawal (IDCW) option. In this option, the MF pays out dividends and the net asset value (NAV) dips to the extent of payout.
These payouts are taxable in your hands at your marginal slab rate. There is TDS beyond ₹5,000 of IDCW (dividend) received in a year from MFs, at 10%, and you have to pay the remaining tax, as per your applicable slab rate. The other option in MFs is growth, where there is no payout; the earnings of the fund remain in the NAV. You can redeem when you want, at the prevailing NAV and encash your returns.
The taxability of MFs in the growth option depends on the underlying investments, which are equity and debt. In debt funds, returns are taxable as short-term capital gains, which again is at your marginal slab rate. In the growth option of equity-oriented funds, it is about your period of holding. Short-term holding period is defined as one year and long term is defined as more than one year. Short term capital gains are taxable at 15%, plus surcharge and cess as applicable. Long-term capital gains, from equity stocks and equity-oriented MFs, are exempt from tax up to ₹1 lakh per financial year. Beyond ₹1 lakh, equity-oriented MFs are taxable at 10% plus surcharge and cess as applicable.
Also read: Trapped in escalating insurance premium
Equity stocks
Investing in equity stocks has a long history in India. Taxation of the gains are similar to equity MFs discussed earlier. If you sell the shares within one year of purchase, it is short-term capital gains, taxable at 15% plus surcharge and cess. Long-term capital gains beyond ₹1 lakh per financial year are taxable at 10% plus surcharge and cess. Investing in bonds or debentures is gradually gaining ground.
The coupon (interest) on bonds/debentures is taxable in your hands at your marginal slab rate. From this financial year, there is TDS on the coupon on bonds. Capital gains from bonds will happen if you sell the bond prior to maturity, at a profit.
For bonds listed at the Exchange, a holding period of more than one year is defined as long term. Long-term capital gains from listed bonds are taxable at 10% plus surcharge and cess. Short-term capital gains are taxable at your marginal slab rate.
Apart from the usual investment avenues, insurance combines risk coverage with investments. There are unit linked insurance plans (ULIPs) and conventional insurance policies with investments combined. Premium contributions beyond ₹5 lakh per financial year in traditional policies and beyond ₹2.5 lakh in ULIPs are taxable. Within these limits, maturity proceeds are tax-free, provided premium contribution per year is within 10% of sum assured in the policy. However, insurance should be what it is supposed to be i.e., risk coverage only. Ideally, it should not be looked at as an investment vehicle.
As mentioned earlier, your investment decisions should be based on the suitability of it and not tax efficiency. Within the boundaries of suitability, how do you generate tax efficiency? As we observe from the discussion above, equity stocks and equity-oriented MFs offers tax efficiency on a holding period of one year and longer. The crux of your allocation to equity is your risk appetite and investment horizon.
The longer the better, as it takes care of market cycles. In the interim, there will be fluctuations in the market and in your portfolio holding statements. As long as you have a long enough horizon, say 10 years, history shows that you will get decent returns. On top of it, you get tax efficiency.
(The writer is a corporate trainer and author)