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Investment plan: Pick the right option
BS Reporter in Mumbai | December 10, 2007
The treatment of gains and taxes are the two essential features that differentiate these plans. If evaluating the returns from an investment at a point of time, there is no difference among the three options. The difference emerges in an implicit form with respect to the applicable taxes.
In case of a growth plan, gains made are reflected in the higher NAV of the fund. The capital appreciates and investors can cash in on this by redeeming units. Under this option the decision of booking profits is that of the investor.
In case of dividend plans the fund manager takes a call and distributes gains amongst investors in the form of dividends. Under the dividend payout option, the dividend is paid to you and the NAV falls by the extent of such a payout. It is up to you to reinvest that money as you deem fit. In case of dividend reinvestment, the dividend is paid out by issuing additional units. Hence the dilemma of reinvesting your dividends is taken care of. The biggest benefit here is that the discretion of booking profits is left to the fund manager.
Taxation of Equity Funds
As far as the growth option is concerned, one needs to pay taxes on capital gains. If the units are sold within a year of being bought, a short-term capital gains tax of 10 per cent is levied. There is no tax payable on long-term capital gains which comprise of units held for more than a year.
Dividends are tax free in the hands of the investor. When a fund house distributes dividends, it is required to pay a dividend distribution tax (DDT). There is no DDT applicable on dividends declared by equity and balanced funds.
So if you intend redeeming units within one year of investing in a fund, you would be better off under the dividend option. But such a strategy is not foolproof for investors will be at the mercy of the fund house to distribute dividends. Not to mention the fact that an investment time horizon of less than a year is not advisable for investing in equities.
Taxation of Debt Funds
The treatment of debt funds is slightly complicated. Dividends distributed are liable to DDT which implicitly eats into the corpus that could be potentially in your hands. In case of money market or liquid funds, the DDT (inclusive of surcharge and cess) amounts to as much as 28.33 per cent. For all other type of debt funds, the DDT (inclusive of surcharge and cess) amounts to 14.16 per cent for individuals and Hindu Undivided Families. The tax for all other assessees stands at 22.66 per cent.
For all other debt funds, if you are in the middle or higher tax slab paying 20 per cent or more as income tax, then the dividend option will make more sense over the short term. For the long-term debt investor, growth would be the way to go.
Making the right choice
Some people prefer using the dividend payout option as a source of regular income. The glitch with this is that investors are at the mercy of the fund house to declare dividends. And funds are not obligated to declare dividends even under a monthly dividend plan. Moreover, the quantum of the payout will not be consistent. Our advice is not to opt for the dividend option as a monthly source of income. You would be better off instituting a Systematic Withdrawal Plan for this.
The dividend option is suitable for those who would like to book profits regularly and redirect such money to other financial instruments such as a fixed deposit. For all other purposes, the growth option offers more flexibility in decision making.
There is an exception though. In case of ELSS or tax planning funds the dividend payout plan is superior. This is because the dividends paid out are not subject to a three-year lock in. And while you cannot redeem your principal units for three years, under the dividend payout option you can at least avail of the profits made here. However, one should absolutely steer clear of the dividend reinvestment plan under this category because the additional units received are subject to the three year lock in.
Do I have to include the Securities Transaction Tax (STT) when calculating my capital gains tax?
As a rule, STT is not deductible in calculating your tax liability. The generally accepted methodology is to take the full value of the transfer, deduct the cost of acquisition and calculate the applicable tax rate on this amount.
Therefore, don't make the mistake of adding back the STT that has been deducted.
Let's say you invested Rs 80,000 in an equity mutual fund. At the time of redemption, the amount is Rs 1,00,250. But out of this amount, you only get Rs 1,00,000 as Rs 250 is deducted on account of STT.
The capital gain will be calculated on the sales proceeds received, which is Rs 1,00,000 in your case. Therefore, short-term capital gains will be Rs 20,000 and you will have to pay a short-term capital gains tax at the rate of 10 per cent (plus cess and surcharge) on this amount.
Does it not make sense to invest in a Ulip? After all it gives the benefit of investing along with an insurance cover
Our views on mixing insurance and investment can be summed in two words: DON'T EVER! The lure of Unit Linked Insurance Plans (Ulips) is in its convenience - it combines insurance with investment. But what may appear as convenient may not make sound investment sense.
It is difficult to monitor the performance of the investment component in a Ulip. A common misconception is that the entire amount you pay is invested by the insurance company. Not so. From the premium paid, the insurer deducts charges towards life insurance (mortality charges), administration expenses and fund management fees. So only the balance amount is invested. Also, Ulips have very high first year charges towards acquisition (including agents commissions).
In order to evaluate the return generated by a Ulip, you need to take into consideration only that portion of the premium that is invested in a fund. This information is not easy to come by. You will have to go through all the policy account statements to arrive at this amount. Even if you do so, you will not know which stocks the fund manager has invested in, which sectors he is betting on, how concentrated his portfolio is and other such details. Neither are you aware of his stock picking capability and how strong his research team is (if he has one).
Also, with a Ulip, you have to block your money for long periods of time. So you sacrifice on transparency and liquidity.
If the tax benefit is another factor that draws investors, then an Equity Linked Savings Scheme (ELSS), which is a mutual fund with the identical tax benefit under Section 80C, is a better option. Here too, you get the tax benefit and the investment is locked only for three-years.
If you have already invested in a Ulip, you might as well stick it out. Because all the charges, which could be as high as 60 per cent in the first year, begin to taper from the fourth year onwards. So you will have to stick on for at least 10 - 15 years to make sure you get some decent return on your investment.
The high costs, difficulty in evaluation, lack of transparency and low liquidity don't make a Ulip a sound avenue to put one's money. The ones who benefit most from Ulips are agents, whose commissions can go up to 25 per cent.
Insurance cannot and should not be an investment. If anyone wants an insurance cover to provide for their dependents, they should opt for a term insurance cover. This is the most basic and cheapest form of life insurance.