Long term capital gains tax on equity; NPS, international fundsIf you are dejected by the imposition of the 10% long-term capital gains tax on equity, here is one piece of advice. First and foremost, I do not think that anyone should sell out or switch out of equity mutual funds solely because this tax has been introduced.

It can be one of several factors used to evaluate equity mutual funds such as valuations, time horizon, risk appetite and so on. After having considered these and other factors, if you still want to look elsewhere, here are a few options.

  1. International funds

Funds investing in stocks of companies listed outside India are called ‘International Funds.’

International funds are treated as ‘debt funds’ for tax purposes. This means that if sold within three years, all gains on them become taxable after at your slab rate. After three years, the gains in them are taxed at 20% with indexation.

Following the imposition of the 10% long-term capital gains tax on equity funds, the tax rate between them and international funds has become similar, because the latter get the benefit of indexation and the former does not. This has removed the tax advantage of investing in domestic Indian companies and funds to some extent. Also, international funds can benefit from the same compounding effect of equities as domestic equity funds. According to Value Research, they have delivered just 8.22% over the past three years. However, this has risen to 16.45% over the past one year.

We discuss some interesting international funds, here.  

  1. ULIPs (Unit-Linked Insurance Policies)

These can invest in equities just like mutual funds and they are tax exempt on maturity under Section 10(38) of the Income Tax Act. They usually have a life of 15 years but this can vary. However before you rush into the next ULIP on offer, consider the following drawbacks:

Charges

ULIPs come loaded with hefty charges. You pay a premium allocation charge, policy administration charge, fund management charge and mortality charge. The IRDA has laid down limits on just how much these charges can eat into your returns for ULIPs of different tenures. These limits begin at a 4% at five years after inception and decline to 2.25% after 15 years since inception. In other words, they come close to the charges on equity mutual funds only after a fifteen year holding period.

Years since policy was purchased Maximum reduction in yield
5 4%
6 3.75%
7 3.5%
8 3.3%
9 3.15%
10 3%
11 and 12 2.75%
13 and 14 2.5%
15 2.25%

Liquidity

If you either surrender a ULIP or fail to pay your premiums within the first five years, you pay ‘discontinuance’ charges as follows.

Year Premium less than 25,000 Premium more than 25,000
First 3000 6000
Second 2000 5000
Third 1500 4000
Fourth 1000 2000
Fifth Nil Nil

Your money is also moved to the ‘discontinued policy fund.’ Here it earns roughly saving bank account interest (currently 4%) and remains locked-in for five years after purchase.

  1. National Pension Scheme (NPS)

The NPS lets you have equity exposure up to 75% of your corpus under the NPS Aggressive Lifecycle Fund and 50% under the Active Choice, making it a reasonable contender in the list of alternatives. Its structure brings it closer to hybrid rather than pure equity funds. However hybrid funds have also been slapped with a 10% tax and hence the NPS becomes worth a look. We discuss NPS returns here.

This option is only really meant for you if you are using equity mutual funds to save for retirement. The NPS locks you in until the age of 60 (save a few exceptions). The NPS is much cheaper than equity funds with pension fund manager fees falling below 0.1% per annum.

The main drawback of the NPS is that only 40% of your corpus is tax-free at maturity. You can read more about the NPS, here.

Author
Neil Borate

Neil Borate is Deputy Editor, RupeeIQ. He can be contacted at neil@rupeeiq.com.