Mutual funds are a better investment option than stocks from a tax perspective; learn why

Although the recently proposed tax on property sales is being reduced, long-term capital gains tax on shares and mutual funds It remains the same. It has been seven years since this tax was introduced and the only change has been the increase in the rate from 10% to 12.5% ​​this year. This is now the uniform rate not only for stocks and equity funds, but for many other types of investments. However, this is where the similarity ends. For investors who want to earn long-term returns and build real wealth through equity-based assets, the tax structure means that careful attention must be paid to where they invest and when they buy and sell those investments.

The most important point to note is that from a tax perspective, it is much more beneficial to invest in mutual funds than in shares. While this has been the case since February 2018, the increase in long-term capital gains tax in this year’s budget has made it much more important. In any case, even before, many investors did not understand this about taxation.

I’ll summarize the underlying principle. All stock portfolios need some buying or selling as individual stocks become more or less desirable. This is true even if you are good at picking stocks and holding most of them for several years. Time passes, circumstances change, companies and markets evolve, and stocks that were once good need to be sold and something better bought. If you are investing in stocks yourself, these transactions will result in a tax liability.

However, in an equity mutual fund, the fund manager makes the equivalent transactions within the fund. You do not have a tax liability because you have not made any transactions yourself. Also, it is not just about the tax amount. Over time, the biggest impact is the growth of this amount. You could hypothetically pay a couple of lakhs of tax on long-term capital gains this year, but if you did not have to, then five years from now, this amount could grow to Rs. 5 lakh. This is an additional multiplier of the tax saved because the money is still available as an investment and earns even more. For long-term investments that compound over the years, this can make a huge difference. Obviously, for compounding to happen, you need to invest in an asset class that does not require you to buy and sell yourself too often. This asset class is essentially a diversified equity fund. I refer to a diversified fund because sector, thematic and other specialized funds are likely to require holding adjustment more frequently, while diversified funds will not.

Another situation where buying and selling investments may be necessary is to rebalance assets. At some point, you may want to move some of your money from equities to fixed income. A good solution is hybrid funds. In fact, a hybrid fund where the debt and equity split matches your desired asset allocation is the most stable investment. It should hardly require any selling until the time you need to redeem it.

There is one interesting caveat that few investors are aware of – the NPS Tier 2 account. This account is basically a collection of low-cost mutual funds that are available to NPS Tier 1 members. Unlike the Tier 1 account, they can be bought and sold like any other fund. However, you can switch from one scheme to another and thus change your asset allocation without incurring any capital gains tax. Every mutual fund investor who is part of the NPS Tier 1 account should carefully study the Tier 2 account and consider these funds as an option available to them. Regardless of which part of the above discussion applies to you, mutual fund investors should be fully aware of the tax implications of their investment choices. It is not something that can be ignored any longer.The author is CEO of VALUE RESEARCH