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Showing posts with label Taxation. Show all posts
Showing posts with label Taxation. Show all posts

Wednesday, July 13, 2011

Returns Should Account For Taxes & Inflation

How much did your investments really earn last year? You can calculate a rate of return with simple math (don't forget dividends if any), but if you don't adjust it for inflation and taxes, you're not getting the real rate of return.

This is the difference between the nominal interest rate and the real interest rate. You want to know the real rate, since that is the only number that means anything.

Think of it this way: the nominal interest rate tells you the growth rate of your money, while the real interest rate tells you how much your purchasing power is growing.

Growing Money

For example, if you make a Rs. 1,000 investment that earns 8% in one year, you end the year with Rs. 1,080. In other words, your money has grown by Rs. 80 (we'll assume no dividends just to keep the illustration simple).

However if inflation is 3% for the year, your Rs. 1,080 is only worth about Rs. 1,050. Inflation devalues not only the interest you earned, but the principal too. Your real rate of return is only 5%.

Investors depending on dividend income or interest from bonds or other fixed-income securities are most directly affected by the costs of inflation.

If you hold a stock, the gains build up until you sell, so it may be possible to avoid the "inflation tax" if you can time the sale for periods of low inflation.

Stocks can generally weather the effects of inflation better than bonds or other savings instruments. Companies can pass on the higher costs of inflation to customers. Of course, this tends to keep the inflationary cycle going.

Taxes

The above exercise adjusted your rate of return for inflation; however, it was purely academic unless your investment was in a tax-deferred account or a tax-free investment.

The other deduction you need to take to reach the real rate of return is for taxes. You don't get to keep - in most cases - all the money you make. The government will want its share too.

Let's return to our example. You invested Rs. 1,000 and earned 8% nominal return for Rs. 1,080. However, inflation is running 3%, so your real rate of return is only 5% giving you purchasing power of Rs. 1,050.

Even though your Rs. 1,080 will only buy what Rs. 1,050 would one year ago, you still have Rs. 1,080 in your account and the government wants a piece. For simplicity sake, let's assume that taxes totaled 20% in your bracket and that this qualifies as a long-term gain.
The government will want Rs. 16 of your Rs. 80 gain in taxes. Now your real bank account is down to Rs. 1,064.

If we reapply the 4% inflation to what you will actually get to keep, we will come up with the real purchasing power your investment returned. This figure is Rs. 1,021 (96% of Rs. 1,064 = Rs. 1,021).

The ugly bottom line is this. Your Rs. 1,000 investment has bought you a real return of 2.1% increase in purchasing power over last year after taxes.

That doesn't sound like much, however if you run all investments through the same exercise, you'll find similar results.

Real returns don't sound as good as nominal rates of return, but they are the truth and not an illusion.

Saturday, October 9, 2010

Taxation on your Mutual Fund Investments

One key point to keep in mind when investing, is how that investment is going to be taxed.

Given below are the facts you need to know regarding taxation of mutual funds:

Equity Funds

As an investor if you have opted for the dividend option, for the reason that you want cash inflows to be managed through dividends, then the dividends which you received under the scheme is completely exempt from tax under section 10(35) of the Income Tax Act, 1961.

If you are caught in the wrong habit of short-term (period of less than 12 months) trading, then you better be ready to forgo your profits/capital gains, if any, in the form of Short Term Capital Gains (STCG) tax. STCG are subject to taxation @ 15% plus a 3% education cess.

If an investor deploys his money for long-term (over a period of 12 months) and thus subscribe to a good habit of long-term investing, then there is no tax liability towards any Long Term Capital Gain (LTCG)

If an investor deploys his money in an Equity Linked Saving Scheme (ELSS), then he enjoys a tax deduction under section 80C of the Income Tax Act, which enables him to reduce his Gross Total Income (GTI). However, this benefit can be availed by investors upto a maximum sum of Rs 1,00,000. Also at the time of exiting (after 3 years of lock-in) from the fund the investor will not be liable to any LTCG tax

Investors will also have to bear a Securities Transaction Tax (STT) @ 0. 25%; this is levied at the time of redemption of mutual fund units.

Debt Funds

Similarly, in a debt funds too, if investors have opted for the dividend option, to manage your cash inflows, then the dividend which the scheme declares will be subject to an additional tax on income distributed. Hence, in such a case investors are actually paying the tax indirectly.

Unlike equity funds, in debt funds, investors are liable to pay a tax on their Long Term Capital Gains (LTCG), which is 10% without the benefit of indexation and 20% with the benefit of indexation.

Similarly, in case of Short Term Capital Gains (STCG), the individual assesses will be taxed at the rate, in accordance to the tax slabs. Unlike in case of equity mutual funds, investors will not have pay any Securities Transaction Tax (STT)