Indian investors need to worry more because tax changes are a regular affair in the country. While some of the changes have benefitted investors, some have been disruptive. One of the main reasons behind the frequent changes have been demands for a ‘level playing field’ by different industries. The banking lobby’s pressure for a level playing field between bank FDs and debt mutual funds resulted in the increase of holding period for long-term capital gains from non-equity funds from 12 months to 36 months. Demand of fund houses for a level playing field between mutual funds and Ulips resulted in imposition of tax on Ulips, should the annual contribution go above Rs 2.5 lakh. The tax on EPF interest was another case in point. All the above changes have the power to affect an investor’s long-term goals. In this week’s cover story, we look at how best one can navigate tax changes to protect one’s goals.
Be ready for more surprises
Investors would do well to brace for more surprises in future. However, it is difficult to predict what the changes will be and when they will be announced. “Due to fiscal stress, the government wants to bring more items into the tax net. So, instead of reducing tax on industry that is demanding a level playing field, it may increase tax on others,” says Gajendra Kothari, MD & CEO, Etica Wealth Advisors.
Since insurance receipts in the form of death claims are tax free across the world, it may remain the same here as well. However, the government has started targeting maturity claims and as a first step, imposed tax on Ulips where the annual premium is more than Rs 2.5 lakh. Don’t be surprised if other products like traditional plans also get added to this list in coming years. Similarly, banks continue to lobby against favourable treatment to debt funds in the form of indexation benefits. Since capital gains are supposed to be for the rich and we are following the west, long term capital gains tax on all products may go up in future.
Grandfathering of earlier investments while effecting tax changes can be a big solace. For example, the new 10% long term capital gains tax on equities is only for investments made after 31 January 2018. Similarly, the new tax on EPF interest is restricted to the amount you invest over and above Rs 2.5 lakh per annum from 1 April 2021. All Ulips bought before the tax change were kept outside the ambit of the new tax. However, one cannot take this grandfathering as a guarantee. There are several instances of drastic changes being made without allowing grandfathering. For example, increase in long term debt fund definition from one year to three years was done without grandfathering and investors who invested in one year debt FMPs suffered. They ended up paying short term capital gain tax instead of long term capital gain tax.
Make the most of the current tax regime
Uncertainty about future taxes should not stop investors from milking the current tax regime. Money saved through tax planning is equal to money earned and therefore, investors should not give up any current benefit over fears that these benefits may be withdrawn in future. Fully utilising the Rs 1.5 lakh 80C limit is the first step. For example, part of your investments for long term goals like retirement, child’s education, etc. can be done through tax saving schemes instead of normal equity schemes. While both are generating similar returns, the tax benefit makes ELSS a superior product. Since effective investment after considering the tax saved is less, actual returns from ELSS will also be more.
Tax benefit makes ELSS a superior product
Since net investment after considering the tax saved is lower, the actual returns from ELSS funds are higher than from other equity fund category.
Data as on 27 April Source: Value Research
Instead of keeping money in normal bank fixed deposits, long term investments can be routed through FDs with 80C benefits or better yielding small savings products like PPF. Similarly, investors can utilise the exclusive Rs 50,000 tax deduction available under Section 80CCD (1B) for NPS. NPS has generated better returns due to its low cost structure. This means the additional tax benefit and returns negate other
issues with NPS, like compulsory lock-in till retirement, a portion of corpus needed to be used for buying annuity, etc.
NPS returns have been better than that of mutual funds due to its low cost structure
The additional tax benefit justifies the lock-in till retirement and the other issues that are peculiar to NPS.
Data as on 27 April. Source: Value Research
Up to Rs 1 lakh earned as long-term capital gains from equities per year is tax free. So, booking long-term capital gain of Rs 1 lakh every year can be another smart strategy. Should you book more than Rs 1 lakh because there is a chance of the rate being increased in future? No. “Don’t book more than Rs 1 lakh per annum from equity investments. You will lose if the government decides to make it tax free again,” says Raghvendra Nath, MD, Ladderup Wealth Management.
Another option is to go opt for products where the tax status is publicly stated. “Since products like tax free bonds are issued like that, the same can’t be made taxable later. I think some products like PPF may also remain tax free due to political pressure,” says Anil Rego, Founder & CEO, Right Horizons.
Defer your tax as much as possible
Since tax deferred also works for you by compounding your wealth, it makes sense to defer tax as much as possible. “Defer tax as much as possible by limiting your investments in accrual assets like bank FDs and going for products like mutual funds where tax incidence occurs when you sell them. Since there is no inheritance tax in India now, this accumulated wealth can get transferred to your legal heirs as tax free later,” says Nath. However, please note that India had inheritance tax earlier, known as estate duty. It’s return cannot be ruled out.
Power of tax deferment
An investment will grow more if the tax paid on interest can be deferred.
There is no need to avoid all accrual products, returns from which are added to the total income. At the same time, you need to restrict the income to remain outside the tax net. For example, retired HNIs can keep some money in taxable accrual products like bank FDs, RBI bonds, Senior Citizen Savings Scheme (SCSS), etc. Similarly, people in the highest tax bracket can keep some part of their contingency in the savings account because up to Rs 10,000 interest is tax free.
Incorporate higher tax in your calculations
While it makes sense to hope for the best, you should always be prepared for the worst. “Though this will increase the required investments, it makes sense to incorporate possible future tax in the goal calculations,” says Rego. How much should be the assumed future tax rate? “Ideally, planning should be done in such a way that your goals are protected even if all incomes are taxed at the highest rates in future. Though PPF interest may not be brought under tax net, I prefer to assume a prudent 10% tax on it as well,” says Kothari.
You can also arrive at an ideal initial investment amount by doing a sensitivity analysis. “Be conservative in your estimates while computing goals and you may also want to do a sensitivity analysis based on possible changes in future tax rates to see its impact on your cashflows and goals,” says Unmesh Kulkarni, Managing Director & Senior Advisor, Julius Baer India. For example, assume that you are investing Rs 1 lakh in an equity funds and expect a return of 12% per annum. In this case, the Rs l lakh will grow to Rs 5.47 lakh in 15 years and will result in an accumulated capital gain of Rs 4.47 lakh. The final corpus will keep reducing with increased tax incidence.
A scenario analysis will tell you if the net corpus will be enough to meet your goals
You need to invest more in lumpsum or increase SIP amounts with every increase in taxes to protect your goals.
Provide additional cushion
Want to assume that current tax rates will remain stable? No problem, provided you include additional cushion so that your goals are not threatened with unforeseen events. “Future taxation is totally outside our control and we have to live with it. So creating additional buffer, especially for critical goals, is the best available option,” says Vikram Krishnamoorthy, Sebi RIA.
Please note that this buffer will come at additional cost. “Being super conservative and saving more now is equal to giving up the current spending and quality of life. Since this is also not a great outcome, do it for non-negotiable goals,” says Gaurav Rastogi, CEO, Kuvera Wealth. However, Kothari feels that being super conservative is better than being in a deficit. “Negative surprises are always painful. If we were conservative and planned better for covid, the present situation would not have happened,” he says.
Think beyond taxation
While tax planning is important, don’t confuse it with goal planning. Don’t restrict investments to Rs 1.5 lakh allowed under 80C or additional Rs 50,000 allowed under 80CCD (1B). You need to invest much beyond these limits to achieve all your goals. More importantly, understand that some high return generating asset classes may remain so despite the introduction of taxes. “Equity allocation should be based on risk profile, age and time period to goal. Even if taxes on gains from equity increases, equity will still remain the best option for 10-year holding period,” says Subramanya S.V., Co-founder & CEO, Fisdom.
Volatility is a part of equity investing. “Start rebalancing into debt as your goal approaches. Though this will increase taxes, this will reduce the risk of not achieving the goal,” says Rastogi. The tax burden will increase because the money shifted in the last few years needs to be parked in bank FDs where the interest will be taxable or in debt funds, gains from which will be added to your taxable income as short term gains. In addition to protecting against normal stock market volatility, this move will also protect you against any sudden spike in equity tax close to your need, that too without grandfathering.
Review plans every 3 years
You need to review your plans on a regular basis or whenever there is a major event, both internal or external. Internal events include marriages, new births or deaths in the family, increase or decrease in family income, etc. External events are major tax rate changes, structural shift in return profile of asset classes, etc. Long-term capital gains from equity and interest on EPF for contributions above Rs 2.5 lakh a year becoming taxable are examples of major tax changes. “Just like future tax, goal calculations are also based on another assumption, future returns. Since both these assumptions need to be updated periodically, review the financial plan every three years,” says Rego. Over the years, returns from all asset classes have come down.
Review plans to factor in falling returns
Interest rates of bank fixed deposits have been falling steadily.
Another goal planning assumption is how much money you need to meet a goal and that itself can move after a few years. “Assumed goal value may also change, at times, with the situation. Usually, people tend to keep ambitious goals in good years, but they may pare down their expectations and goals during bad times,” says Kulkarni.