On the 22nd of June 2005 the Sensex, for the first time in its history crossed the 7000 mark. At that time, investors big or small couldn’t wipe the smile off their face. Wonder how many investors would show even a hint of a smile if the index were to go back to 7000 now. I know at the end of the day, these are just statistics --- however, it does boggle the mind to think of the fact that from 7000 to 10725, the Sensex has yielded an eye popping 80% annualized return. Therefore, the most common question that investors are asking nowadays is --- what next? Should we take market exposure at this point in time? And if we do, what stocks should we buy? (Read more - Investment strategies for the risk averse) I don’t have the answers to these questions. What I am doing however is I am leaving these decisions to my professional Portfolio Manager. Now, I am not someone who is commonly referred to as an HNI (High Networth Individual). Then how come I got myself a professional Portfolio Manager? Really simple…and all of you can also avail of one if you haven’t done so already. (Read more - Investment tips that can turn beginners into PROs) Look around you, there are professional portfolio managers just crying for your attention. It’s just that you don’t recognize them. All the Mutual Funds are ipso facto your portfolio Managers and what’s more --- they offer more transparency and tax benefits as compared to the Portfolio Management service available to your common HNI !! Believe it. Let’s understand how. First the basics
Mutual Funds themselves may offer many variations in terms of Open-ended, Close Ended, Sectoral Funds, Balanced Funds, Monthly Income Plans, Fixed Maturity Schemes, Gilt Funds, Income Funds and so on. However, the Income Tax Act only recognizes two types of funds --- Equity Funds and Non-Equity Funds. Period, tax benefits differ for each one. An equity fund, to put it simply, means a fund that invests more than 50% of the money in equity shares. Budget 2006 has enhanced this limit to 65% from the 1st of June, 2006. An equity fund has been bestowed enormous tax benefits by the Act. Lets see what these are: For an equity fund: - Long-term capital gains are tax-free
- Short-term capital gains are taxed at only 10%
- Dividend is not subject to dividend distribution tax
- Redemption of units is subject to a Securities Transaction Tax (STT) of 0.2%. Budget 2006 has enhanced this rate to 0.25%
On the other hand for a non-equity fund: - Long-term capital gains are taxed @20% with indexation or 10% without indexation
- Short-term capital gains are to be added to the other income of the investor and taxed at applicable slab rates
- Dividend is subject to a 14.025% distribution tax. For corporates, firms etc. this rate is 22.44%
- There is no STT applicable
No wonder they say higher the risk, higher the benefit.  Budget 2006 does not differentiate between Open-Ended and Close-Ended Funds
Close-ended funds are those that have a fixed maturity date. Open-ended funds are on tap --- there is no maturity date as such. Prior to Budget 2006, only open-ended equity funds had freedom from dividend distribution tax. Close-ended funds, even if investing 100% in equity had to bear this tax. This anomaly has been rectified by the Budget. (Read more - Equity funds: Look beyond past performance)
Another variant of an Equity Fund
Then there are ELSS funds (Equity Linked Savings Schemes). ELSS, to put it simply are equity funds that offer a tax benefit over and above those mentioned above. Any investment in an ELSS fund offers Sec. 80C deduction i.e. the amount invested is deductible from your taxable income. However, Sec. 80C has a cap of Rs. 1 lakh…so only an investment up to Rs 1 lakh gets the tax benefit. The following table illustrates the same with a simple example: | Taxable Income | Rs 6,00,000 | | Investment in ELSS | Rs 1,00,000 | | Net Taxable Income | Rs 5,00,000 | Now, tax saving presupposes a lock-in. In other words, without a lock-in period, Sec. 80C benefit is just not available. All instruments under Sec. 80C have a lock-in and so does ELSS. But at just 3 years, it is one of the instruments where money is blocked for the least amount of time. Also, ELSS funds in general have been found to out-perform their equity diversified counterparts. This happens essentially as the fund manager has the money at his disposal over the long-term without having to cater to everyday redemptions. Therefore, regardless of the tax benefit, even investing over Rs. 1 lakh may be an idea to consider. Incidentally, on the 3rd of November last year, the authorities came out with a circular regarding ELSS funds. Without going into the pointless details, there was a controversy created by the circular. Subsequently on the 11th of November, a clarification was issued that basically restored things back to status quo. Therefore, as of now, for investments in ELSS, the Sec 80C benefit is available up to the full extent of Rs 1 lakh, regardless of the income level of the investor. So many options --- which to choose?
Here I don’t mean investment options but options within the investment. As most investors would know, mutual funds come with essentially three options - Dividend
- Dividend Reinvestment &
- Growth
The dividend option is pretty straightforward, in that, as dividend is tax-free, those investors who prefer some kind of regular cash flow should opt for the same. This also means automatic periodic profit booking which is good form in a rising market (as it is currently). (Read more - Dividends: Look before you strip!) With the current tax structure, there is no difference between the Dividend Reinvestment and Growth options. However, say there is a distribution tax imposed in the future. Then, it is much better to choose the growth option than suffer the distribution tax. (Incidentally, even on Dividend Reinvestment, distribution tax is imposed and units are allotted only on the net dividend amount). However, envisage a scenario where there is a long-term capital gains tax imposed. In such a case, the Dividend Reinvestment option proves to be fiscally more beneficial. Therefore, options should be chosen as per cash flow requirements and tax incidence as is currently applicable. To Sum
Mutual Funds provide the most optimum mix of Return, Risk, Liquidity and Tax Efficiency. Of course, provided they are used well. If you had a personal Portfolio Manager, he would have told you that equities have known to earn the highest return in any asset class over the long-term. The operative words being long-term. (Read more - The smart guide to picking the best MF) As explained above, your mutual fund is your personal portfolio manager. Allow him to do his thing. Frequently getting in and out only hampers the journey…. and when it comes to successful investing, believe me, it is the journey that is more enjoyable than the final destination. The writer may be contacted at sandeep.shanbhag@gmail.com More from Experts... For more columns by Experts click here | 
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