Tax Implications

The previous chapter discussed the relationship between risk and return and how these factors influence investment decisions. Ravi and Priya discover that tax implications are another crucial consideration as they proceed with their investment journey.

Investors can improve their planning by understanding how taxes affect investment returns. This chapter discusses the different taxes that apply to investments, including capital gains and dividend taxes, and how they vary based on the asset class and holding period.

Several taxes apply to investments. The two most common taxes are capital gains and dividends. Capital gains tax is the tax you pay on your profit when you sell an investment for more than you paid. Therefore, the ₹500 profit you make from selling stock you purchased for ₹1,000 and sold for ₹1,500 is subject to capital gains tax.

Capital gains tax is divided into two types: short-term and long-term. If you sell an investment within a year of buying it, it’s considered a short-term capital gain (STCG), and you’ll pay a higher tax rate. If you hold the investment for more than a year, it’s a long-term capital gain (LTCG), and the tax rate is generally lower. This difference encourages long-term investing.

In India, the tax on short-term capital gains for equities is 15%, while long-term capital gains exceeding ₹1 lakh are taxed at 10% without indexation benefit. The tax rules change with the asset class and holding period; hence, always refer to the latest rates.

The next important one is the dividend tax. When a company pays dividends, it means giving away some of the profits. Dividend income in India for residents exceeding ₹ 5,000 attracts 10% taxation. It is the nature of this income to deduct tax at source. That means the recipient will receive a dividend less than the TDS amount. Thus, if ₹ 1,000 is your dividend income, the 10% tax deducted from there would be ₹ 100, and you receive ₹ 900.

Tax laws change, and investments can be taxed differently. For example, debt funds are taxed differently from equity funds. Debt funds are usually levied higher taxes on long-term capital gains than equity funds. Equity funds enjoy some tax advantages because they are considered riskier and help encourage investment in the stock market.

Mutual fund investors have to consider taxes, too. All the capital gains and dividends from mutual funds are liable for taxation. However, tax-efficient options, such as tax-saving funds or ELSS, offer benefits under Section 80C of the Income Tax Act. These funds have a lock-in period of three years and reduce your overall tax liability. You could explore the ELSS funds for investment if you intend to save on taxes.

Remember that you do not always have to pay taxes every time you sell an investment or get dividends from a security. In this case, if you own any stock or mutual fund and the market value increases, you would gain unrealised capital. You only pay a tax on the gain made, in this case, once that investment is sold. Here comes the concept of tax deferral-you can hold off paying taxes until it's time to sell, at your discretion.

Tax planning is essential, especially when considering long-term retirement goals. Understanding how taxes affect your returns will make sense. If you invest in a taxable account, review your portfolio periodically to minimise your tax liabilities. Tracking capital gains, dividends, and expenses such as brokerage fees helps you better understand your tax situation.

Conclusion:

During this process, Ravi and Priya continue to learn about the tax implications of their investment types. They now understand the value of long-term investment planning and how ELSS funds help them lower the burden of variable aspects of their investments by saving income taxes.

Their confidence in handling this aspect of investing increases with their level of taxation knowledge. The choice of mutual funds and which options best suit a person's risk tolerance and financial objectives will be discussed in the upcoming chapter.