What, Why & How of Long Term Capital Gains (LTCG) Taxes

On Wednesday, February 1, 2018, Union Finance Minister Arun Jaitley presented his third Budget.  

Here’s the key highlight of the Budget:

“Long Term Capital Gain (LTCG) Tax on equity Mutual Funds”

Needless to say:

A large number of long term equity MF investors are miffed by the government and are confused about what they should do.

So we decided to spill the beans on LTCG tax, its impact and new investment strategy for long term equity MF investors.

So, let’s jump right in.

What is Long Term Capital Gains (LTCG) Tax?

Long Term Capital Gains (LTCG) Tax is the tax liability of a taxpayer on benefits/returns/profits gained in the long term by assets including (but not limited to) stocks/shares, share linked investment plans, and real estate.

Why has the LTCG Tax Suddenly Become So Important?

In 2004-05, long term capital gains on stocks and shares were tax exempted. However, the government of India reintroduced the LTCG tax on shares and stocks, on the 1^st of February 2018. As per the new LTCG tax rules stipulated by the government, those earning profits over Rs.1 lakh from sales of shares or from investment in share-oriented products such as equity mutual funds held for one year or more will need to pay 10% tax on the overall profit.

What is the 'Grandfathering' Clause in LTCG?

‘Grandfathering’ clause protects the interest of those who have already invested in long term capital instruments such as sale of stocks or equity mutual funds as per the prevalent tax laws. LTCG’s ‘Grandfathering’ clause will provide exemption to those who have already earned profits from the sale of shares or have generated capital gains from equity mutual fund schemes before the tax comes into effect. As per the new rules, LTCG tax on profits generated from sales of shares or equity mutual fund schemes earned till the 31^st of January 2018 will be exempted (grandfathered).

Who will Come Under the Radar of LTCG Tax?

According to the new rules, anyone booking profits from sales of stocks or capital gains from equity mutual fund schemes after 31^st of March will have to pay LTCG taxes. This means existing investors have the option to sell their stocks till March without having to pay any taxes on the profits generated by the sale. In addition, the LTCG tax will apply only to those who will generate profits over Rs.1Lakh in a particular financial year. This means if an investor makes long-term gains of Rs.2 lakhs (in a FY), LTCG tax will apply only on Rs.1 lakh (which is over and above the Rs.1 lakh limit.)

What Should Investors Do Now?

We’re sure the introduction of LTCG tax on equity mutual fund schemes will encourage more and more investors to invest in Unit Linked Insurance Plans (ULIPs). Given the new taxes, ULIPs pose as a brilliant investment instrument that offer the triple benefits of investment, tax savings and a comprehensive insurance protection.

ULIP allow investors to invest in different capital gain options including debt and equity funds. As ULIPs are typically insurance plans, there are no taxes on the maturity benefits. But what’s really special about ULIPs is the fact that even partial withdrawals are tax exempted. Besides, those investing in ULIPs can claim tax deductions on premiums paid under Section 80C of the Indian Income Tax Act 1961.

Why are ULIPs Better than Equity Mutual Funds?

After the introduction of LTCG taxes, ULIPs have become better saving instrument as against Mutual Funds. Here are 5 key reasons why ULIPs are the better option:

1. Long-Term Investment – You probably already know that the best way to grow your wealth is by investing it for long time. But you’ll be surprised to know that for only 40% mutual fund investors, the average holding period was more than 2 years, whereas for a large majority (60%) mutual fund investors, the average holding time was less than 2 years, according to 2015 Assocham Report. On the contrary, ULIPs have a minimum lock-in period of 5 years encouraging long-term investment without having to fear for their tax liability on maturity proceeds.
2. Cost Proposition - Mutual funds attract a variety of charges including Fund Management Charges, Distribution charges, Expense Ratio and Exit Load. Remember, 60% mutual fund investments are made for 2 years or less. Furthermore, these charges are relatively higher. On the other hand, most online ULIPs have Fund Management Charges and expense ratios lower than that of Mutual funds for life cover.
3. Tax Benefits - After the LTCG tax rules come into effect, the maturity proceeds of long-term equity mutual fund schemes (1 year or more) for more than Rs.1 lakh will attract a tax liability of 10 per cent. Whereas the maturity proceeds of ULIPs are eligible for tax deduction. Besides this, tax exemption is also allowed on partial withdrawals. In addition to that, the premium payment for ULIPs is eligible for tax deduction under Section 80C.
4. Protection – Mutual funds are pure investment instruments and do not offer any protection to the investors in case of an emergency. Contrarily, ULIPs offer the triple benefits of insurance protection, investment and tax savings to investors.
5. Fund Switching Option – Mutual funds allow investors to switch funds amongst the different available schemes. However, this option comes with a break in investment period. ULIPs are much more flexible as compared to mutual funds. ULIP investors can easily switch between equity to debt funds.

Over to You!

So there you have it – the what, why and how of LTCG taxes. The trend that seems clear, at this point, is that equity mutual funds will lose out on the popularity polls and ULIPs will take the centre stage in the months to come. But one thing that we’re sure of is the fact that more awesomeness is set to prevail in the Indian Life Insurance Industry.

May we see bigger, better investment opportunities from 2018 and beyond!

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