Mutual Funds versus equities: Which is the better tax saving option?

Equities as an asset class have not only emerged as a wealth creating asset class over the long term but they are also extremely tax efficient. As a stock market investor you have two approaches to equities. You can opt to directly open an equity trading account with a broker and buy equities into your demat account. Here you can select the stocks you want to buy and also take decisions on churning your portfolio. The second method is to invest indirectly through equity mutual funds. Here you allocate a certain corpus to the equity mutual fund and the fund manager decides what stocks to buy and what stocks to sell. Of course, this is a transparent process and you can see the portfolio of your fund each month in the fact sheets published by the fund. While equities have a stock price, the mutual fund will have an NAV (net asset value). Both equities and equities have emerged as solid wealth creating asset classes over the long term. For tax purposes, an equity share and an equity mutual fund are given similar treatment. But there are some very subtle differences between the tax treatments of direct equities versus equity mutual funds.

How are dividends taxed in both the cases?

When you own equities, you are paid dividends on an annual basis out of the profits made by the company. Nowadays most companies pay interim dividends during the year too. Normally, the average dividend yield on the index is around 1.5% in the Indian context. In case of equity mutual funds, you will get dividends only if you opt for the dividend option. If you opt for the growth option of the mutual fund then you will only see the NAV appreciating. But how are dividends treated in both the cases? How are dividends taxed in the hands of the investor? In case of investors in equities and equity funds, the dividend received is tax-free in the hands of the investors. However, effective the Union Budget 2016, a new additional tax has been introduced on equity dividend. Now shareholders will have to pay a tax of 10% if the total dividend received by them during a financial year exceeds Rs.10 lakh. This includes dividends from all equity holdings. However, in case of equity funds there is no such upper restriction and it is entirely tax-free in the hands of the investors.

Let us also look at the Dividend Distribution Tax (DDT). In case of direct equities, the company declaring and paying the dividend has to deduct 15% DDT before paying the dividend. Effectively, this reduces the amount of dividend in the hands of the investors. When an equity fund pays out dividends, there is no such thing as DDT. That is more because when dividends were originally paid out by the company to the mutual fund, the DDT is already deducted. This is more to avoid double taxation.

How are capital gains taxed in both the cases?

Actually, in case of capital gains the treatment of capital gains on equity and equity funds is exactly the same. The following 2 rules are applied both in case of equity funds and direct equities:

  • If the shares or equity funds are held for less than 1 year then it is classified as short term capital gain (STCG). The concessional rate of 15% STCG tax will be applied in the case of equities and equity funds if held for less than 1 year.

  • If the shares or equity funds are held for more than 1 year then it is classified as long term capital gains (LTCG). The LTCG is tax-free both in the case of direct equities and in case of equity mutual funds.

There is one very important thing to remember. For a fund to qualify as an equity fund, it must have an exposure of minimum 65% to equities. If the holding falls below that mark then it will be treated as a non-equity fund and will lose out on the above tax benefits.

Tax rebate for investment in equities and equity funds…

There is a special class of equity mutual funds which is called Equity Linked Savings Schemes (ELSS). These are exactly like any equity fund but the only condition is that it entails a compulsory lock-in period of 3 years from the date of investment. Investment in an ELSS entitles the investor to 30% tax rebate (assuming you are in the highest tax bracket). This benefit is available under Section 80C of the Income Tax Act and has an overall limit of Rs.200,000. ELSS is one of the assets qualifying for Section 80C rebate and this section also includes other outlays like PPF, Employee Provident Fund, and Life insurance premium, tuition fees for children and home loan principal; apart from ELSS. The rebate is available in the year of investment. That means if you invest Rs.20,000 in the year, then you get a rebate of Rs.6000 in the same year. That reduces your effective investment to just Rs.14,000 and that substantially enhances your return on investment when calculated on the effective investment. There is no such tax rebate available for investment in direct equities.

In pure tax-saving terms, while the broad tax treatment for equity and equity funds is the same, there are surely some finer points that put equity mutual funds at an advantage over direct equities. That is something you need to bear in mind when making a choice!

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