They brought it back.
And you already know what I am referring to.
Ending almost one-and-a-half decade long tax holiday, investors now face a non-zero tax environment as far as long term capital gains from equity is concerned.
Long Term Capital Gains (or LTCG) arising from the sale of equity shares and equity mutual funds will be taxed at 10%, if total capital gains in a year exceed Rs 1 lakh.
I know you have already got your dose of LTCG and its impact and this and that via newspapers, experts debating on television channels all day long for weeks and various online publications. So in all probability, I have nothing new to add here. But I will voice my thoughts here without getting into too much technicalities… but will nevertheless have to resort to some numbers & tables.
So… where do I begin 🙂
To be honest, the investors who were until just a few weeks back accustomed to earning tax-free long term capital gains would be affected. They will have to prepare themselves to accept the ‘new’ reality of paying tax on equity related long term capital gains at a rate of 10%.
For me personally, zero was always better than 10 percent. 😉
I don’t want to add more and say anything about how I feel as I know that you know what I want to say. 😉
But the fact of the matter is that the reality has changed for all of us. And from a personal finance and investment perspective, the restoration of LTCG tax on equity is not a small change.
Some people I know are really unhappy and calling it unfortunate. I feel that there are very few things we can control. And tax environment is something that we can’t. There is no point getting into theoretical arguments about whether LTCG was justified or not. We simply need to adapt and move forward. That’s the only way forward.
But I must say, that the grandfathering clause was pleasantly innovative. So many things that could have gone wrong were smartly avoided via that clause. So… thank your grandfathers first!
Generally speaking, keeping something tax free for very long can be detrimental. And tax-free profits was never a fundamental right. So it had to happen eventually.
Infact, the return of taxation of LTCG from equities was expected for many years and hence, cannot be called as a very big surprise. But not many expected this to happen immediately. But this government is known for taking such steps. It was a bold step (though not as bold as demonetization which impacted investors, non-investors and everyone in between). I don’t know how much revenue would the government actually collect from it as of today. But as our economy grows and markets are poised to rise further in years to come, the LTCG tax collection would trend upwards with time. And that is something which the government wants to milk slowly and steadily.
Let’s talk a bit about SIP flows that have been hogging the limelight for last few years first.
I don’t think that a favourable tax regime (zero LTCG tax) was the major reason for the surge in domestic flows into the equities market. But its possible that the removal of the tax advantage may affect sentiment and flows, more so if markets don’t continue their upmove as many new investors expect is their birthright! Maybe it’s too early to say anything. I don’t know. I hope that the recent trend of more and more household savings going into financial assets is not curbed.
But I must clarify one thing…
With or without taxation, equity is the best bet for retail investors in the long run. There is no denying that.
Although LTCG may have a near-term sentimental impact it won’t wreak havoc in long term.
People were perfectly fine paying much higher taxes on much lower returns from FD and other assets. So this move may have made equity a bit less attractive for time being. But for long-term inflation-beating returns, equities has to form a major part of any sensible investor’s core portfolio.
All that has changed is that from now on, investors need to factor in an additional 10% tax burden on equity investments. And this alters the risk-reward equation for equities somewhat.
Pardon me but to move further, I need to do some number crunching…
So have a look at the tables below:
As is evident from the table above, in long term the impact of a 10% tax will be limited on the CAGR (after taxes).
So for example, if you invest Rs 1 lac (assuming 12% constant return) for 20 years, the value of your investment would be Rs 9.64 lac before taxes.
But since you will need to pay 10% on your LTCG (above Rs 1 lac), the amount you receive will reduce to Rs 8.88 lac. That is, you pay a LTCG tax of Rs 0.76 lac – which is an impact of 8.84% of your original capital gains had LTCG not being taxed.
So due to LTCG tax of 10%, your CAGR is reduced from 12.00% to 11.54%.
This reduction is marginal in percentage terms. And to be fair, this should not stop anyone from investing in equities. Isn’t it?
But as I said, the marginal-ness is in percentage terms. This may not seem much but let’s remember that we began with just Rs 1 lac in above example.
Let’s run the numbers with a bigger Rs 50 lac investment and you will see what I am trying to say
Focus on the last row (25th year).
Your investment of Rs 50 lac has become Rs 8.5 Cr after 25 years of 12% returns.
But welcome LTCG taxation and the amount you will get in hand will be Rs 7.7 Cr.
A small reduction of CAGR from 12% to 11.56%.
But actually, it means Rs 79.9 lac less in your hand!
That’s not a small amount for most readers of Stable Investor. 😉
Let me show you something else…
In both the above examples, we assumed 12% ‘constant annual’ returns. That’s fine as a CAGR but in reality, we will see ups and downs which on an average will result in 12% returns.
So let’s do a more realistic assessment:
- Assume you invest Rs 10 lac at the start.
- The money is to be invested for 25 years.
- At the end of every year, you liquidate all your investments and pay taxes if need be (if you are in profits).
- This approach is seemingly unrealistic. But lets remember that in reality, you will exit some of your bad investments every few years to change funds, rebalance you allocations, etc. So you will exit and enter every now and then. If not every year, then atleast every few years. This particular scenario gives you a perspective of what happens with several exits between 1st and 25th
- Within the above framework, we will test two scenarios
- Scenario 1 – The CAGR of this 25-year period is 12% (for zero LTCG tax). But the actual annual returns are fluctuating (shamefully similar to Sensex annual return figures)
- Scenario 2 – A ‘different’ series of 25-year annual returns that would also have delivered 12% CAGR (for zero LTCG tax).
Here is Scenario 1:
And here is Scenario 2:
Spend some time on both these tables. Notice the difference in sequence and quantum of annual returns. In a zero-LTCG-tax scenario, ideally both would have ended up with similar corpus.
A 12% CAGR for 25 years on an initial investment means a corpus of Rs 1.7 Cr. Now compare this will the corpus you get in above two scenarios ~ Rs 1.2-1.3 Cr. The difference is much more than 10%. Depending on the actual numbers and various other factors, the LTCG tax could cost much more than just 10% (for some cases, it might cost lesser). And this is something that people need to realize. Not easy but necessary to revise our expectations.
To be fair, the detrimental impact of LTCG tax will be negated ‘somewhat’ due to the availability of the set-off clause for Long Term Capital Loss.
As per clarification provided by the CBDT, long-term capital loss arising from sale or redemption on or after April 1st, 2018, will be allowed to be set-off against long term gains and any unabsorbed loss can be carried forward to subsequent eight years for set-off against long-term capital gains.
So this practically means, that returns will be slightly better than what the table highlights but still less than zero-LTCG scenarios.
And I am not even counting the possibility that the investor might throw in the towel at the wrong time and exit his long term investments due to lack of patience. 🙂
We can continue exploring more scenarios. But that won’t help any further. So without delving any deeper into the numbers, the point to realize is that the actual return that you get in hand will depend on a lot of factors now – like whether you sell fully or partly, after every year or after every few years, return % in years you sell, return % in years when don’t sell, quantum of set-off for gains vs losses, taxes you pay in years you sell, etc…etc…etc.
It always was a moving target.
Now the target is moving a lot more. 😉
In theory, one can put money in lumpsum at the start and remain invested till the end of 25-30 years to see a small reduction in CAGR (as highlighted in first two tables previously). But in reality, investors will sell some of their holdings and buy something else. And each such switch will have tax implications, leading to less capital being available for compounding subsequently.
As I said, the actual and eventual impact would differ for each investor depending on their buying and selling decisions. But the impact of the tax on long term capital gains on returns at times may be much larger than just 10%.
Let’s move on…
I have another small concern.
The difference between short-term and long term capital gains tax was 15% earlier. Now its just 5% (i.e. 15% tax for short term and 10% for long term). Will this reduction in difference push people towards ‘shorter’ term investing? It is possible to an extent. Probably, it’s a side effect that market will willingly digest.
But on the other side, it is also possible that people will avoid exiting investments in a hurry to defer paying taxes – so in a way, it may bring in a sense of long term’ness’ in the investments being made.
Earlier, long term investors had the luxury to switch from one investment to other every year (if need be). But now, this luxury will cost them 10% of their returns. And over time and depending on the number of such switches, the tax-related costs will add up. So ideally, this should make investors much more disciplined and avoid unnecessary exits.
So what’s the way forward?
From government’s perspective, they are back in the business of taxing capital gains from equity. Who knows what they might think of in future? Will they increase the tax to 20% with or without indexation? We don’t know but its possible. Will they change the definition of long term from currently 1 year to lets say 3 years? We don’t know but its possible. There is a non-zero probability that change will happen. More so if we are talking about decades, like remaining invested for periods of 20 or 30 years. Change will be gradual in small doses. Due to political and psychological reasons, governments and those in power will avoid making too many changes in one go. So we need to remain open to the thought that things might change again in near future.
And I haven’t addressed the concept of utilizing the exemption of Rs 1 lac capital gains which remain tax-free every year, if booked.
Mathematically speaking, it can save about Rs 10,000 a year which again atleast theoretically will be available for compounding. That’s fine. But this will be useful for small portfolio size and may not remain of much use as time progresses and your portfolio size increases (and puts you in rich and HNI category).
So should you book profits each year to lower equity LTCG tax? You can do it. But for it to make sense, your portfolio size should not be very large.
LTCG & your Financial Goals
If you invest according to your long term financial goals, LTCG will definitely impact you and your portfolio eventually if not immediately. That’s a no brainer.
Many investors and me included, run SIPs to meet their life goals – retirement (or early retirement), children’s education, travels, house purchase, etc.
Till now, it was fairly simple and most considered reaching some of these long term goals without much of a tax-impact. However, now that an LTCG tax of 10% has been introduced for equity, its possible that the investors will need to save more to meet their real financial goals, as money left in hand after paying LTCG tax will be lesser.
As a first thing, and I may be repeating – people need to keep their expectations in check and recalibrate it to the new and future tax environments. We cannot predict what will happen tomorrow. But having some buffer is fine and advisable.
Depending on various factors, chances are that the increase that investors need to make in their regular investments may not be a very big amount. The exact calculated additional amount that they need to invest to make up for the fall in equity portfolio return will depend on the investment horizon, return expectations and few other factors. For simplicity, assume that it may increase by about 10% or more too. Your financial adviser can help you create a goal-based financial plan that will have adequate tax-buffers.
Having said that, if the financial plan has made use of reasonable assumptions (like 11-12% equity returns), then there are decent chances that higher returns from the market will take care of your needs (even post tax ones too). But if the plan assumes 19-20% kind of returns from equity, then you need to put up your hand and revise your expectations first and ask your advisor to not fool you! And ofcourse increase your on-going investments.
That brings me to the important point of rebalancing the portfolio.
This includes buying-&-selling to preserve strategic asset allocation as well as existing dud investments and entering better ones.
All this will now cost 10% of the profits being booked.
So people need to avoid churning their portfolios unnecessarily and frequently to avoid this ‘new cost’. This also means that it makes sense to choose funds which have a good record of doing well in long term and which require least churns.
This is something that those focusing on asset allocation framework need to be careful about.
But avoiding taxes should not be a reason to remain put in bad investments. The notional loss by not being in the better funds will be much more than your tax savings.
I think I have already added to the noise surrounding LTCG and its impact on long term returns from equity. 🙂
My apologies for that.
To summarize, LTCG is the new reality which no doubt is a negative for investors. But my advice is to accept, adapt and move on.
Equity still offers best inflation-beating returns, even after all the taxes and has the potential to outperform returns from most other savings and investment options.
Good, sensible and disciplined investing will take care of all such similar issues that come up every now and then.
Being an advisor, I can confidently say that instead of worrying and getting confused about things that cannot be controlled, investors should simply concentrate on their financial goals and keep investing (now a little more) in a disciplined manner through systematic investment plans (SIPs) and for the long term.