Thursday, August 5, 2010


The revised draft tax code has stipulated that though the pension to be received by individual, interest to be received from PPF and dividend paid out of equity or mutual funds would be free of income tax yet the capital gains would be taxed at the same rate of the income tax from individual tax payer. That means capital gain tax will be realized at 10%,20% and 30% as the case may be. At present capital Gains is exempt from tax after one year of investment.

The new provision is going to be harsh news for any middle class investors. There are many investors who do not prefer dividend option because they would rather like to have more money in future than during the present time. Why many people do not want dividend option? They do not prefer dividend option because during the working life they continue to get steady income from their employment or from business and profession. An employee of private institute gets salary monthly and that would be sufficient for them to cover their monthly expenses. They would need extra money only after they retire for their livelihood then. Though all government employees, teachers of Colleges and schools, now a days, get pension to take care of their life after retirement yet non governmental professionals including journalist, lawyers, doctors, artists, singers, Painters and nurses in non governmental organization do not get any pension. These people always invest and opt for growth mode for they want larger income after retirement. The new revised draft tax code has demolishes and ignores this perception of Middle class. How?

The tax on capital gains from long-term equity holdings, as described above, bound to drastically reduce the returns of equity. This reduction will go far beyond the actual percentage of tax that will be paid. For example, over a ten year period, an effective capital gains tax rate of ten to fifteen per cent could reduce a typical investor's returns by above 40 per cent , perhaps at times it would be much more than that . If investors are to limit the damage, then they will have to understand how this tax will actually affect them. Can middle class investors be able to avoid this stipulation? Prima facie it would be difficult unless they switch to Dividend option. But that is no solution since they do not need the money presently.

How a long-term capital gains tax rate of just 10/15 per cent can cause far greater damage to their returns? This is because over the years all the mutual funds or shares do not perform consistently all the time. Magnum vision fund was doing exceedingly well till 2006 . But thereafter it became a laggard fund due to various reasons. Many investors switched to Magnum contra fund for better returns without any harm to their investment. This is how even a long-term investor would need to switch between investments at some point. Today, as long as investors do hold a stock (or an equity mutual fund) for more than a year, the gains are tax-free and so he can happily sell his holdings and put the money in another investment.

But once the long-term capital gains tax, as per the revised tax draft, is implemented, investors are bound to get a tax hit on the returns every time he redeem the investment. A fine example has been illustrated by Value research. Let us analyse the example. “Consider a ten year investment that is yielding 20 per cent an year. In ten years an investment of Rs 1 lakh at this rate would grow to Rs 6.19 lakh. If the long-term capital gains are taxed at 15 per cent for your income bracket, you would end up with Rs 4.41 lakh post tax returns, an effective rate of return of 18.3 per cent. But if this investment was switched to a different share or fund just twice in those ten years, the final post tax return would be just Rs 2.24 lakh “. How our readers would like that? Is it not a kind of robbery? Person who opted for dividend would get much more return .The person preferring for growth mode would get less. So in the process the money set aside for his old age would get robbed due to new tax burden. So under the circumstances what is to be done? I have a definite suggestion to our readers in case revised tax code is implemented and Capital gains tax is taxed as stipulated.

While selecting Mutual funds or shares please ensure that you subscribe to the funds/shares which have given consistent returns( opt for four star or five star funds) for over last five years at least. Please do not change the boat of investment in mid stream. Select only a few shares or a few Mutual funds. The portfolios should not be more than six funds and/ or six shares. Hold on to those shares for a period of ten years. You would be able to gain that way. If you do not switch more than once you would gain substantially as per the example given above. One our readers asked me whether do I have any alternative suggestion? Yes, here is an alternative suggestion:

The middle class people can opt for Dividend option and whenever he gets dividend the same amount can be saved in his PPF account up to the limit. In that event he neither have to pay tax either in case of equity dividend or incase of PPF. He would be the winner all the way. That is why when you invest in modern time you should have your own financial advisor or read books on Personal Finance that would guide you to steer clear of the hurdles of investment hassles.

The statement of Value research is prophetic that the real gains of long-term investments come from compounding of returns, and repeated taxation would have a strong de-compounding effect. This pattern of taxation would reward not long-term investment per se, but only being long-term in the very same investment. However, keep it in mind two suggestions given by us to tackle your investment and you would be the winner surely


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