- How do taxes affect my returns?
- What taxes should I consider when choosing investments?
- What is tax harvesting?
- What are tax-saving Mutual Funds?
- What are other tax-saving instruments?
- How to pay less income tax to invest more?
How do taxes affect my returns?
As per the Income Tax Act, any profit earned from capital assets such as stocks, Mutual Funds, Gold, Real Estate, etc., is termed “capital gain.”
These capital gains are subject to tax depending on the type of investment.
There are two kinds of capital gains tax:
- Short Term Capital Gains Tax (STCG Tax)
- Long Term Capital Gains Tax (LTCG Tax)
Depending upon the asset class that you have invested in, the taxes on short-term capital gains can vary from being charged at your maximum marginal rate (so you end up paying whatever rate your income tax bracket is) to as low as 15% (plus the applicable surcharge and cess). Meanwhile, long-term capital gains — which apply to investments held for more than a year in case of investments in stocks or equity mutual funds and atleast 36 months incase of debt mutual funds or bonds - often come at a lower rate (along with indexation benefits as may be applicable).
Clearly taxation works in your favour if your investment horizon is for a longer time frame!
Stocks and Equity Mutual Funds are the best instrument for making long term investments as not only is the minimum holding period for qualifying as a long term capital asset lower at a minimum of one year, but also the taxation rates are lower as compared to rates on other asset classes such as Bonds, Gold or Real Estate.
While you cannot avoid paying tax on capital gains but you sure can plan your investments accordingly to be tax efficient.
Consider the impact of taxes in the following table:
What taxes should I consider when choosing investments?
Equities are more optimized for saving on taxes in the long term, which is more than 1 year. The longer you hold on to your mutual fund units, the more tax-efficient they become. The tax on long-term capital gains is comparatively lower than the tax on short-term gains.
You cannot avoid paying tax on capital gains; instead, you can plan your investment accordingly to be tax efficient.
What is tax harvesting?
Tax harvesting is the practice of selling investments that have decreased in value in order to realize a capital loss, which can be used to offset capital gains and reduce the overall tax liability. This can be done in order to manage the overall tax burden and potentially save money on taxes.
Benefits of tax harvesting include:
- Reducing the overall tax burden by offsetting capital gains with capital losses
- Potentially saving money on taxes by reducing the amount of taxable income
- Allowing for the opportunity to reallocate investments in a more tax-efficient manner
- Potentially improving the overall risk-return profile of an investment portfolio by selling underperforming investments and reinvesting the proceeds in more promising opportunities.
What are tax-saving Mutual Funds?
As an individual you can avail of various tax saving instruments that qualify U/s 80C of the Income Tax Act of 1961 and save taxes by investing upto a maximum of Rs. 150,000/- in the various instruments as described below. There is an additional benefit of Rs. 50,000/- U/s. 80CCD(1) if an individual decides to invest in any instrument that comes under the “National Pension Scheme” (more on this below)
An Equity Linked Saving Scheme (ELSS) is an equity mutual fund that invests primarily in equities. They are a special category among mutual funds that qualify for tax deductions under Section 80C of the Income Tax Act, of 1961.
As a result, ELSS is popularly known as a tax-saving mutual fund.
The returns you could earn on them are directly linked to the stock market’s performance, so it is suitable to invest for the long term.
The benefits of ELSS are
- You can avail a tax deduction on investments up to Rs. 1.5 lakh every year.
- These funds also have a mandatory lock-in period of three years. This is one of the shortest lock-in periods among all tax-saving investment avenues available.
- They have the potential to earn higher yields compared to other traditional tax-saving options
Here’s a comparison between ELSS and the other tax-saving instruments
What are other tax-saving instruments?
Besides ELSS there are other tax-saving instruments that exist -
- National Pension Scheme
The NPS (National Pension System) is a government-supported pension system in India that allows individuals to save for their retirement. Contributions made to the NPS are eligible for tax benefits and the accumulated savings can be used to purchase an annuity at retirement to provide a regular income.
- Public Provident Fund
PPF (Public Provident Fund) is a long-term saving scheme in India that is offered by the government. It allows individuals to save money and earn interest on it, and the savings are eligible for tax exemptions.
- Senior Citizens’ Savings Scheme
This scheme is an ideal investment option for people above 60. The overall tax exemption for people above 60 is 350,000 rupees and for those above 80 is 550,000 rupees.
The SCSS investment limit is 1.5 million rupees, with a tenure of five years, which can be extended by three years. The scheme pays 8.7% on investments, which is the highest among small savings schemes.
- Sukanya Samriddhi Yojna
The Sukanya Samriddhi Yojna is a savings plan for the education and marriage of a girl child in India. It offers tax breaks and tax-free interest on the money saved. Any guardian of a girl under 10 years old can open an account. There is a limit of 150,000 rupees per year on investments and the interest rate changes every quarter.
- Unit Linked Investment Plans
ULIPs (Unit Linked Insurance Plans) offer both insurance and savings through investments in market-linked assets. They have a lock-in period of 5 years, but can have a longer duration and offer tax-free income. Child ULIPs waive premiums if the parent dies and continues investing in the policy.
- National Savings Certificate
National Savings Certificates (NSC) are a fixed-income investment in India that offer tax breaks and a return of around 8% per year. Interest earned on the investment is taxable, but if it is reinvested in the scheme, it is eligible for tax deductions. NSC has a 5-year tenure.
How to pay less income tax to invest more?
One strategy to increase your earnings on your investments is to increase the principal amount. By paying less income tax, you're able to increase your investments on a yearly basis. Here are a few ways you can pay less income tax, regardless of the tax bracket you fall in -
1. Tax savings for business owners
To avoid paying taxes, business owners might claim travel expenses as a part of business costs.
2. Charity donations
Not every donation qualifies for a tax deduction. Only contributions made to designated funds are tax deductible. Tax deductions for money spent making a donation to a political party have no upper limit.
3. Health insurance premium
A person may deduct up to Rs 25,000 for their own insurance premium as well as their spouse's and dependent children's insurance premium.
If your parents are below 60 years of age, you can deduct an additional/separate amount for their insurance premium up to Rs 25,000; if they are above 60, it can be up to Rs 50,000.
4. Amount received through inheritance
The money you receive through a will or by being a legal heir is entirely tax-free because India has no inheritance tax.
5. Wedding gifts
Any kind of wedding present received from direct relatives is exempt from taxation under the Income Tax Act.
The most that can be spent on presents from friends or unrelated individuals is Rs. 50,000. Gifts that exceed this amount will be subject to the applicable tax slab.
Tax implications are essential when making an investment. This is where financial advisors can help you plan a long-term strategy to minimize your capital gains tax. Stack is a wealth management service that manages and optimizes your investment portfolio for you.