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Taxation & Asset Allocation – A Definitive Guide

Learn how to review your Asset allocation and taxation to make the best of investment returns and tax benefits.
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While investing for your financial goals, the asset allocation strategy requires you to invest in a mix of asset classes like equity mutual funds, fixed income products, gold etc., in varying proportions. Furthermore, once you have finalised your asset allocation, you need to make sure that it is tax-efficient while choosing a financial product within an asset class. Hence taxation & asset allocation go hand-in-hand.

General taxation framework

As a citizen, it is your civil duty to pay income tax on your annual income. The Indian Government uses the tax collected for the country's development like building infrastructure, healthcare, education, strengthening security, providing welfare schemes to the poor, etc. An individual's income is taxed based on the income tax slab that he/she falls in.

Before arriving at the final taxable income, the Government allows certain exemptions and deductions to individuals. Therefore, in this article, we will keep our discussion limited to:

Deductions in respect of investments in specific financial products as provided under Section 80C and treatment of capital gains on equity mutual funds, gold and certain fixed income products.

How to make efficient use of tax benefits within asset allocation

In the above section, we saw the asset allocation strategy requires an individual to invest in various asset classes like mutual funds, fixed income products, gold etc. Let us understand the tax benefits that these asset classes provide and how to use these tax benefits efficiently.

Equity mutual funds

From a tax benefit point of view, we can divide equity mutual funds into 2 categories: Equity-linked saving schemes (ELSS) and other equity mutual fund schemes. Investments in ELSS are eligible for deduction from taxable income under Section 80C of the Income Tax Act. The maximum deduction that in a financial year is Rs. 1,50,000. Investments in other equity mutual funds are not eligible for deduction under Section 80C.

When investing in equity mutual funds, as part of your asset allocation strategy, you can give preference to ELSS for investments of up to Rs. 1,50,000 every financial year. For incremental investments beyond Rs. 1,50,000, you can choose other equity mutual fund schemes as per your risk profile. For ELSS, there is a lock-in period of 3 years, whereas, for other equity mutual fund schemes, there is no lock-in period.

Taxation of mutual fund capital gains:

When you sell your mutual fund units, the profit/loss made is known as capital gain/loss. From a taxation perspective, the capital gain/loss treatment for ELSS and other equity mutual fund schemes is the same.

Short-term capital gains tax:

The capital gain made on equity mutual fund schemes (where 65% or more of the scheme money is invested in equity shares) held for less than a year is known as short-term capital gain (STCG). The short-term capital gains (STCG) tax is charged at 15% on the STCG.

Long-term capital gains tax:

The capital gain made on equity mutual fund schemes held for more than a year is known as long-term capital gain (LTCG). In a financial year, the first Rs. 1 lakh LTCG is exempt, and the incremental LTCG exceeding Rs. 1 lakh is charged at 10% long-term capital gains (LTCG) tax.

Fixed income products

After equity mutual funds, let us discuss the second component of asset allocation: fixed income. Investors can choose from a range of products in the fixed income category. Some of these include public provident fund, bank fixed deposits, debt mutual funds, etc. But, first, let us discuss the taxation aspects of each of these.

Public Provident Fund

Among various fixed income products, the Public Provident Fund (PPF) is one of the most tax-efficient investment products. As part of your asset allocation, you can invest the debt component of your investment portfolio in a PPF account.

Tax benefit at the time of investment:

Investments in PPF are eligible for deduction from taxable income under Section 80C of the Income Tax Act. The maximum deduction in a financial year is Rs. 1,50,000.

Interest is tax-free: The annual interest credited to your PPF account is tax-free.

Maturity proceeds are tax-free: The maturity proceeds you will receive from your PPF account are tax-free.

While PPF is a tax-efficient investment option, it comes with a 15 year lock-in period. However, it provides some liquidity in the form of loans and partial withdrawals with specified limits.

Debt mutual funds

An investor should invest his/her emergency fund money in liquid mutual funds (classified as debt mutual funds).

Investments in debt mutual fund schemes are not eligible for deduction under Section 80C of the Income Tax Act.

In non-equity schemes (debt mutual fund schemes), if they are held for less than 36 months, then the capital gains are classified as STCG. In the case of debt mutual fund schemes, the STCG is added to an individual's income and taxed as per the income tax slab.

If debt mutual fund schemes are held for more than 36 months, then the capital gains are classified as LTCG. The LTCG tax is charged 20% on the LTCG with indexation benefit in debt mutual fund schemes.

Bank fixed deposits

Bank fixed deposits are one of the most favoured investment options for the Indian audience. Therefore, we can classify bank fixed deposits into 5-year tax-saving fixed deposits and other fixed deposits from a taxation perspective.

Investments in a 5-year tax-saving bank fixed deposit are eligible for deduction from taxable income under Section 80C of the Income Tax Act. The maximum deduction in a financial year is Rs. 1,50,000.

Investments in other bank fixed deposits are not eligible for deduction under Section 80C of the Income Tax Act.

The interest earned on all bank fixed deposits, whether 5-year tax-saving FD or other FDs, is taxable. The interest is added to an individual's income and taxed as per the individual's tax bracket.

We have discussed 3 fixed income products for the debt component of asset allocation. Here is how they compare from the taxation point of view:

PPF investment qualifies for a tax benefit; interest is tax-free, maturity proceeds are tax-free.

Investments in debt mutual funds are not eligible for deduction. STCG tax is charged as per the individual's tax slab. LTCG tax is charged at 20% on the LTCG with indexation benefit.

Investment in a 5-year bank fixed deposit qualifies for tax benefit. The interest is taxable.

An investor may give preference to PPF as it is the most tax-efficient option. However, if you are looking for tax benefits at the time of investment, you may consider a 5-year tax-saving bank fixed deposit. Park your emergency fund in a liquid mutual fund scheme. From a taxation point of view, it may not be the best option. However, it provides safety of capital, ease of access, and instant liquidity, which is the primary purpose of the emergency fund.

Gold

Gold has been a traditional favourite investment option for Indians. Just like equity and fixed income, gold also is an essential component of asset allocation. Usually, when equities don't do well during times of economic uncertainty, it is gold that glitters investors' portfolios.

For example, when the equity markets fell in the first half of 2020, gold gave one of the best returns in a decade. Hence, it is crucial to invest a certain percentage of your portfolio in gold as part of your asset allocation.

While Indians continue to invest in gold for ages, the ways of investing in gold have evolved. Earlier, the only options for investing in gold were physical jewellery and coins/biscuits. But, in the last 15 years or so, new ways of investing in paper/digital gold have evolved. Some of these include:

  • Gold Exchange Traded Funds (Gold ETFs)
  • Gold Fund of Funds (Gold FoFs)
  • Sovereign Gold Bonds (SGBs)
  • Digital Gold

Taxation of gold

Whether you own physical gold (jewellery, coins, biscuits, etc.) or gold in electronic format (Gold ETFs, FoFs, digital gold, etc.), the taxation is the same. The only exception is SGBs which we will discuss separately.

Short-term capital gains tax:

If gold is held for less than 36 months, then the capital gains are classified as STCG. The STCG is added to an individual's income and taxed as per the income tax slab.

Long-term capital gains tax:

If gold is held for more than 36 months, then the capital gains are classified as LTCG. The LTCG tax is charged at 20% with indexation benefit.

Taxation of sovereign gold bonds (SGBs)

The taxation of SGBs is different from the taxation of other forms of gold discussed above. The SGBs pay an annual interest rate of 2.5% and have a tenure of 8 years. You can sell them on the stock exchange any time after listing. The investor can redeem pre-maturely with RBI between the 6th and 8th year before maturity. The investor can hold the bond for the entire tenure of 8 years and redeem it on maturity with the RBI. The taxation differs depending on when the bond is sold/redeemed before maturity/redeemed on maturity.

Short-term capital gains tax:

The bonds are tradeable on the stock exchange. If the bond is sold within 3 years, the capital gains will be classified as short-term capital gains (STCG). The STCG will be added to the individual's income and taxed as per the income tax slab.

Long-term capital gains tax:

The selling through the stock exchange: If the bond is sold on the stock exchange any time after 3 years, the capital gains will be classified as long-term capital gains (LTCG). The LTCG tax will be charged at 20% on the LTCG with indexation benefit.

Long-term capital gains tax exemption on pre-mature redemption with RBI:

After the completion of 5 years of the bond's tenure, the investor has the option to do pre-mature redemption with the RBI on coupon payment dates (semi-annually). The investor can exercise this pre-mature redemption option twice a year, during the 6th to 8th year. On pre-mature redemption with the RBI, the long-term capital gains tax is exempt.

Long-term capital gains tax exemption on maturity redemption with RBI:

After completing the bond's tenure of 8 years, it will be redeemed with the RBI. On maturity redemption with the RBI, the long-term capital gains tax is exempt.

Taxation of interest: The SGBs pay an interest rate of 2.5% per annum on a semi-annual basis. The interest amount is taxable. The interest is added to an individual's income and taxed as per his/her tax slab.

SGBs are exempt from LTCG tax on either pre-mature redemption/maturity redemption with the RBI and pay an interest rate of 2.5% per annum; SGBs should be the preferred way of investing gold.

Asset allocation with tax efficiency

Once you decide on your asset allocation, you should choose financial products that can give you good returns and the best possible tax benefits within every asset class. For example, based on your asset allocation, you can choose to invest in the following products:

Equity:

Give preference to Equity Linked Savings Scheme (ELSS) up to Rs. 1,50,000 for tax benefits. For incremental investments, you can choose other equity mutual funds.

Fixed income:

Give preference to Public Provident Fund (PPF) as it gives tax benefit at the time of investment, interest is tax-free, and maturity proceeds are tax-free. However, depending on your requirement, you can also choose to invest in debt mutual funds or bank fixed deposits. Invest your emergency fund in a liquid mutual fund.

Gold:

Give preference to Sovereign Gold Bonds (SGBs) as they are exempt from long-term capital gains tax if redeemed (pre-mature/maturity) with the RBI and pay an interest of 2.5% p.a.

To get your asset allocation based on your risk profile and start investing in mutual funds to achieve your financial goals, download the Glide Invest App now from Google Play Store or Apple App Store and get started.

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