While investing in any financial asset it is not only important to look at the right asset class suiting to your risk appetite, higher returns but also you have to consider the time horizon to stay invested as well as the returns that are net of taxes.
For example if you invest Rs. 1,00,000 each in two different funds such as Fund A & Fund B. The annual returns for these funds, i.e. Fund A gives 11% before tax and Fund B gives only 8% per annum, but no tax to be paid. This means, investment of Rs. 1,00,000 each in these two fund option will fetch you Rs. 10,000 (from Fund A) and Rs. 8,000 (from Fund B). Since Fund A gives 11 % pa i.e. straight Rs. 11,000 in a year you should not get enticed as this return is only pre-tax.
If you come under 30% tax bracket then your actual return from Fund A will be Rs. 7601 i.e. 7.60% annual yield which is of course lower than the returns given by Fund B with an annual yield of 8.00%. (See the table below)
But in case you are in 10% or 20% tax bracket then choosing Fund A will be better idea than going with Fund B. This is because, you could get 9.87% or 8.73% annual yield from Fund A if you are in 10% of 20% tax bracket where you get only 8.00% as annual yield in Fund B. (See the table below)
With the above illustration you must have understood, while choosing investments it is important to look at the investment option which gives better tax adjusted returns than higher gross returns.
Following is a table which shows the comparison of tax implication between Fixed Deposits, Debt Funds/FMPs and Equity Investments. For illustration purpose I have taken the investment horizon for 372 days i.e. plus 1 year and annual pre-tax returns of 10% in each case.
FYI, in a Debt Fund/FMPs, the Long-term capital gains (LTCG) tax (earnings from a fund held for one year and above) without indexation is 10 per cent, while it is 20 per cent with indexation. Short-term capital gains (STCG) tax is deducted according to your income tax slab while any returns Bank or Corporate deposits will get added to your income and taxed according to your tax slabs. The tax on long term gains from Equity investments are nil, but short term gains of equity investments (less than 12 months) are taxed at 15% straight.
The illustration shown above, clearly says even if the returns offering/expected are same, the eventual returns depend on the tax liability on them. For e.g. As per above, if someone would have investment Rs. 10,00,000 for plus 1 year in FD at 10.00% then his net annual return will be 6.91% only. If you would have invested in Debt Funds/FMPs then your net yield would have been 9.68% or 8.97% with or without indexation respectively. Since you know Equity related investment like Direct Equities and Mutual Funds, if you stay invested for more than 1 year, the income earned will be termed as Long Term Capital Gains (LTCG) and in that case you do not need to pay any tax on the income earned. So if you would have invested Rs. 10,00,000 for more than a year and you earn 10% returns then there won’t be any tax liability, so your net returns will be 10% per annual.
So next time when you invest, ask yourself; you are Investing Just to get “Higher Returns or Taxed Adjusted Returns”.