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Here's how you can make your returns more tax efficient
November, 25th 2014

While paying taxes when necessary is understandable, paying more taxes than necessary is not! Therefore, ensuring that your portfolio has the utmost tax efficiency is one of the key factors that can help you in improving your portfolio returns. While it is true that tax efficiency alone cannot guarantee investment success, a tax-aware investment strategy can make a substantial difference to your portfolio's ultimate size.

Remember, tax efficiency is important for both short-term as well as long-term investing. However, it is common to see investors keeping large sums of monies in low-yielding savings bank account for months, especially when they are not sure when they will need this money. Of course, the fact that they feel safe putting money in the bank is another reason why they prefer traditional investment option over market-linked products offered by mutual funds.

Although mutual funds are perceived to be riskier than traditional options like bank deposits, the fact remains that they offer a variety of funds for different time horizons and if one makes the right selection, it can make a huge difference to the returns i.e. both gross as well as post tax and that too without compromising on safety and liquidity. For example, there are funds like liquid, ultra short term and short-term income funds that are ideal for short-term parking of funds. Since these funds invest primarily in money-market instruments and short-term debt instruments, they can be considered as a safe investment option. Moreover, being open-ended funds one can withdraw money at a day's notice. However, it is important to choose the right option i.e. growth or dividend reinvestment/payout to improve tax efficiency of returns.

Considering that short-term capital gains from a debt fund i.e. any gains on investments redeemed within three years is taxed at one's applicable tax rates, those investors who belong to tax bracket of 10 or 20 per cent should opt for "growth" option. Although the tax rates applicable on interest from FD and short-term capital gains on a debt based fund are the same, these funds have the potential to deliver higher returns than traditional investment options. As for investors liable to pay tax at 30 per cent, dividend re-investment option would be a better bet as the applicable Dividend Distribution Tax (DDT) to be paid by the fund is 28.325 per cent. Since dividend is tax free in the hands of investors, the tax outgo will be lower.

For investors belonging to the highest tax slab of 30 per cent looking to invest for short term, there is another option in the form of arbitrage funds. An arbitrage fund is an equity-oriented scheme which seeks to generate income through arbitrage opportunities emerging out of mis-pricing between the cash market and the derivates market. In other words, arbitrage funds capture the "interest" element in the equity market and offer an opportunity for investors to earn higher returns, without taking an equity market exposure. Although arbitrage funds fall in the category of equity funds, they are not risky as they invest in stocks and their futures simultaneously. This eliminates the risk of volatility normally associated with equity funds.

For tax purposes, arbitrage funds are considered as equity funds and hence any short term capital gains i.e. any gains on investments redeemed within 12 months is considered as short term capital and is taxed at a flat rate of 15 per cent and long-term capital gains i.e. gains on units redeemed after 12 months is tax free. However, investors can make their return almost tax free by opting for monthly dividend payout offered by most of these funds. Since arbitrage funds are treated as equity funds for tax purposes, the fund is not required to pay any DDT. Therefore, even investors belonging to lower tax brackets of 10 and 20 per cent can also improve their post tax returns.

Evidently, arbitrage funds can be a good alternative for investors for their short term investment needs. These funds have the potential to provide healthy returns during the volatile market conditions and that too with a reasonable degree of safety and in a tax efficient manner. Of course, there are pitfalls too. A depressed stock market may not provide enough opportunities for an arbitrage fund. Besides, it is not necessary that on the day of expiry the price of the stock and its future contract will coincide.
Mutual funds also offer a variety of income funds for medium and long-term term investments such as income funds, gilt funds and fixed maturity plans. Since, every fund that has an exposure of less than 65 per cent in equity is considered as a debt fund for tax purposes, hybrid funds with varying degree of exposure to equities within this limit are also considered as debt funds. If one invests in these funds with a time horizon of three years or more, not only the returns can be much higher than traditional options like deposits and bonds but also the tax efficiency can improve post tax returns considerably. For such funds, any gain on units redeemed after three years is considered as long-term capital gains and is taxed at the rate of 20 per cent after taking inflation indexation into account. Considering that in a country like ours, inflation generally remains at persistently high levels, one would barely pay any capital gains tax.

For investment to be made with a time horizon of more than one year and less than three years, equity savings schemes, a recent addition to the basket of funds offered by mutual funds, can be an ideal option. The schemes invest in a combination of debt, arbitrage and equity in such a manner that exposure to equity is capped at around 20-25 per cent and the aggregate of arbitrage and equity is more than 65 per cent, which qualifies them to be an equity fund for tax purposes.

For investors who want to build a hybrid portfolio investing pre-dominantly in equities for a particular goal, there is an option of either investing in equity and debt fund separately or in an equity oriented balanced fund. If the fund is chosen well, a balanced fund can be a better option as the entire long-term capital gains becomes tax free after one year. Moreover, in a balanced fund, the fund manager keeps rebalancing the asset allocation in keeping with the fund's objectives, without any tax implications on investors. However, if the intent is to build a hybrid portfolio with a bias towards debt instruments, investing separately in debt and equity funds would be a better option. By doing so, capital gains on equity portion can be made tax free after a year and one would have the flexibility to realign the portfolio, if need be.

Similarly, while investing for long-term, it is important to invest in an asset class that has the potential to beat inflation as well as provide tax efficient returns. Equity, as an asset class, fits the bill as it has a proven long-term track record of delivering higher post tax return than other asset classes. However, it is important to minimize portfolio turnover to improve tax efficiency of returns.

To do so, one must follow the right strategy. First, by assessing the tax consequences before making abrupt changes in the portfolio and resisting the temptations to sell investments for reasons other than poor performance and changes in one's personal circumstances, one can reduce the tax burden. Second, one must try to make the right selection of investment options to minimize the need to make changes in the portfolio in the short term. Third, by honouring one's time commitment, one can avoid making haphazard decisions. This also helps in tackling the market volatility from time to time. Last but not the least, by following the strategy of portfolio rebalancing once a year, one can not only book profits during market upturns but also invest in it when the chips are down. Needless to say, a tax aware investment strategy has the potential to ensure that one gets to keep more in the end.

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