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Tax-smarts for mutual fund investors

January 22, 2009

With mutual funds becoming an increasingly popular investment avenue, it would pay to be tax-smart. You could, then, get to keep more of your hard-earned money for yourself, rather than having to cough it up to the taxman...

ULIP contributions on behalf of children eligible for tax deduction

Contributions made to ULIP in the name of spouse and children, major or minor, married or not, are eligible for the Section 80C deduction. So are contribution to PPF and premiums paid on life insurance policies. Unfortunately, NSC-VIII, ELSS and NHB still continue to get step-motherly treatment. In these cases, the deduction is available only on contributions in the name of self.

UTI's ULIP and tax

UTI's ULIP was a reinvestment scheme. At the end of each year, the dividend was declared and reinvested in the scheme at the prevailing sales prices. The investor was required to pay tax on accrual basis. The interest was earlier under the umbrella of Section 80L, which has now been deleted. UTI then converted it into a pure-growth scheme from FY 99-00.

In other words, there are no regular dividends paid and reinvested. The computation of tax liability was quite a complicated exercise and it has become more so from FY 99-00 onwards. It was slated to remain complicated until FY 09-10 for the 10-year term and FY 14-15 for the 15 year term since the initial part of this term would have been dividend payouts and the latter part, the growth.

Thankfully, as a user-friendly measure, UTI computes the tax liability of the investors and submits it along with their redemption proceeds.

FY04 saw capital gains on equity-based schemes become tax-free and, therefore, the growth on ULIP had become tax-free. Unfortunately, FA06 raised the equity exposure for eligibility as equity-based schemes from 51 per cent to 65 per cent.

ULIP is no more equity-based and therefore, the capital gains will have to be taken on year to year basis and the rate payable will be 10 per cent without indexation or 20% with indexation, whichever is more beneficial to the investor. This will be a complicated exercise since the indexation will have to be carried out on each of the installments.

Moreover, there is one difficulty. The bonus paid at maturity becomes due only if the investor continues the policy till its maturity. Therefore, this bonus amount may be considered as short-term capital gains. On the other hand, it may be argued that the bonus is a part and parcel of the plan which is essentially a growth plan and therefore the entire maturity proceeds, would be treated as long-term capital gains with nil cost of acquisition.

Standing instructions for monthly withdrawals

You can avoid the Dividends Distribution Tax by choosing the growth option and effectively convert it into an income (you may look at it as dividend though major part of the withdrawn amount is principal) paying scheme by withdrawing the growth regularly. You may choose to withdraw at any periodicity. All mutual funds accept standing instructions for regular withdrawals.

It is a good strategy to choose just one mutual fund basket for parking your funds. There is no need to distribute your eggs in different baskets. These are very strong baskets and one is not much different from the other if you have chosen the mutual fund basket on basis of good management.

Assume that you have invested Rs 500,000 each in two different mutual funds. Suppose you need monthly Rs. 10,000 for your personal expenses, you should withdraw Rs. 10,000 from only one of them and not Rs. 5,000 each from both. Both the actions are equivalent but the first one reduces your paperwork and also the cost to the mutual fund. The reduction in the corpus of the one will be almost identical with the increase in the corpus of the other.

Partnership firms and mutual funds

Section 42 of the Companies Act prohibits "body corporates" from being a member of a company. Therefore co-operative societies, partnership firms, etc. cannot directly hold shares of any company. However, partners of a firm can hold shares in their individual names by applying money belonging to the firm.

Units of mutual funds were not shares or securities and a partnership firm could therefore hold the units directly in its own name. Now that units have been declared as securities, we are afraid, the units will have to be held in the names of individual partners.

Growth versus Dividend Reinvestment option

The subtle difference between the 'dividend reinvestment' and 'growth' options has vanished for equity-based mutual fund schemes. The long-term capital gains for growth schemes have become exempt whereas there is no dividend distribution tax on dividends. However, the dividend as well as the dividend reinvestment options may cause some problems by way of penalty on dividend stripping while effecting withdrawals. Moreover, the last one or two dividends reinvested may attract tax on short-term gains.

In the case of debt-based schemes, growth was and continues to be much more tax efficient.

Pension plans undesirable

Do not be enamoured by the word 'pension' connected with any of LIC [Get Quote] or mutual fund schemes. Such schemes take undue advantage of your love for the word 'pension' and lock the funds for many years. You will do well by investing in any normal mutual fund scheme, instead. By doing so you are likely to find that as and when you are about to retire, you have more funds on hand than what you could have earned from a pension plan.


[Excerpt from Taxpayer to Taxsaver  by A. N. Shanbhag and Sandeep Shanbhag. Published by Vision Books.]

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