Tax Savings: Why Mutual Funds Offer Better Tax Benefits Than Stocks?

Tax Savings: One of the key advantages of investing in mutual funds, particularly equity mutual funds, is how taxes are handled within the fund

By Chakravarthy V

Tax Savings: When it comes to long-term investing, both mutual funds and stocks are popular choices for building wealth. However, when we look at these options from a tax perspective, mutual funds clearly come out ahead. While the long-term capital gains (LTCG) tax on both stocks and mutual funds has remained consistent since its introduction seven years ago, recent changes have further highlighted why mutual funds are the more tax-efficient option.

Understanding Long-Term Capital Gains Tax

The LTCG tax is currently set at 12.5 per cent, up from the original 10 per cent when it was first introduced. This tax rate applies uniformly to stocks, equity mutual funds, and other types of investments. Despite this uniformity in tax rates, the way taxes are applied to these investment vehicles makes a big difference.

Why Mutual Funds Are More Tax-Efficient

One of the key advantages of investing in mutual funds, particularly equity mutual funds, is how taxes are handled within the fund. When you invest directly in stocks, every time you buy or sell, you create a tax event. If you sell a stock that has appreciated, you will incur a capital gains tax. Over time, these taxes can significantly reduce your overall returns, especially if you're actively managing your portfolio and frequently buying and selling stocks.

In contrast, when you invest in a mutual fund, the fund manager takes care of buying and selling stocks within the fund. As an investor, you only face a tax event when you sell your mutual fund units. This means that the compounding effect of your investments is not interrupted by frequent tax liabilities. The money that would have gone to taxes remains invested, allowing it to grow further.

The Power of Compounding Without Tax Interruptions

Let’s break this down with an example. Suppose you’re investing in stocks directly and you need to sell some to rebalance your portfolio. You might pay a few lakhs in capital gains tax. If that money had remained invested, it could grow significantly over the next few years, possibly doubling in value. This compounding effect is lost when you have to pay taxes on each transaction.

In a mutual fund, since the fund manager handles the transactions, you don’t pay taxes on these internal trades. Your investment continues to grow uninterrupted by tax events, which can make a substantial difference over the long term. For long-term investors, this ability to let your money compound without frequent tax hits can lead to much higher returns.

Diversified Equity Funds: The Ideal Choice

For most investors looking to build wealth over time, diversified equity funds are an excellent choice. These funds spread your investment across various sectors and industries, reducing the need for frequent adjustments and trades. Because they are diversified, they don’t require the same level of active management that sectoral or thematic funds might, further reducing your tax exposure.

Asset Rebalancing With Hybrid Funds

Another situation where you might need to buy and sell investments is when rebalancing your portfolio. For example, as you approach retirement, you may want to shift some of your money from equities to fixed income. One way to do this without triggering a tax event is through hybrid funds. These funds automatically balance between equity and debt based on the fund’s strategy, aligning with your desired asset allocation without the need for you to manually sell and rebuy assets.

The NPS Tier 2 Account

There’s also a lesser-known option for tax-efficient investing: the NPS Tier 2 account. This account functions similarly to mutual funds but offers additional flexibility. If you’re already investing in NPS Tier 1, you can move your money between different plans within Tier 2 without incurring capital gains tax. This feature allows for tax-free rebalancing and is a valuable tool for long-term investors.

No matter your investment strategy, understanding the tax implications of your choices is crucial. Mutual funds offer a significant advantage in this regard by minimising the tax impact of necessary portfolio adjustments. The ability to let your investments compound over time without frequent tax interruptions can make a substantial difference in your long-term returns.

While stocks offer the potential for high returns, the tax efficiency of mutual funds makes them a superior option for many investors, especially those focused on long-term wealth building. By carefully selecting the right mutual funds and understanding the tax advantages they offer, you can maximise your investment returns and achieve your financial goals more effectively.

The author is cofounder and executive director at Prime Wealth Finserv Pvt Ltd.

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