Tax Efficiency: The 12.5% Advantage

The 12.5% LTCG tax rate is not just a lower number! Its advantage comes from:
 

• How it is applied

• What it replaces

• What additional relief comes with it

Let’s understand two different scenarios where you can use the 12.5% LTCG rate to your advantage:
 

Case I: Gains from Debt Mutual Funds are Treated as FD Income

As per the current tax rules, debt mutual funds (having at least 65% exposure in debt and money market instruments and acquired on or after 1 April 2023) do not have LTCG treatment. All the gains are:

• Classified as short-term capital gains (STCG) and

• Charged at the investor’s income tax slab rate. 
   

Now, the holding period has no impact on tax, and any exemption limit or indexation benefit does not exist. Means? If you hold such debt fund for 1 year or 10 years, the gains will always be taxed at the applicable slab rates. After the latest changes, the tax system does not reward time or patience in such debt funds.

Further, capital gain arising on transfer of units of mutual funds (other than equity oriented mutual funds and specified debt mutual funds as defined under section 50AA of the Income-tax Act, 1961) are to be taxed at the rate of 12.5% (without indexation) provided that units are held for more than 24 months. Short term capital arising on transfer of units of such funds is to be taxed at applicable income-tax slab rates.

How to Benefit from the 12.5% LTCG Rate?

From a taxation point of view, instead of aforesaid debt mutual funds, you may prefer equity schemes which are generally very high risk instrument (as per your risk appetite). If they are held for more than 12 months, you can enjoy the following two major advantages:

For More Clarity, Let’s Study An Example theoretically:

Let’s assume an investor, Mr. A, pays tax in the highest tax bracket of 30%. In the current financial year, he earned a capital gain of ₹3,00,000 from selling units of debt mutual funds (having at least 65% exposure in debt and money market instruments). Mr. A has acquired these units of debt mutual funds on or after 1 April 2023 and held for a long term, say 10 years.

Now, these gains will be taxed at Mr A’s applicable slab rate of 30%. The final tax liability would be ₹90,000 + applicable surcharge and health and education cess.

In contrast, if Mr. A had invested in equity-oriented schemes, the LTCG of ₹3,00,000 would have been taxed as follows:
 

• The first ₹1,25,000 would be exempt. Only the remaining ₹1,75,000 (₹3,00,000 - ₹1,25,000) to be taxable @ 12.5%.

• The tax liability would be ₹21,875 (₹1,75,000 x 12.5%) + applicable surcharge and health and education cess.

The tax efficiency? You can save up to ₹68,125 (₹90,000 - ₹21,875) + applicable surcharge and health and education cess, just by switching the mutual fund type (from specified debt mutual fund to equity oriented mutual fund). To avoid manual calculations and get precise answers, you may also use the online LTCG tax calculators. 

Case II: Invest For the Long-Term Investment Horizon 

It is worth mentioning that equity oriented mutual funds still follow a “time-based tax split”. Let’s check the latest long-term capital gains tax brackets below:

As an investor, if you sell your equity oriented mutual fund units before 12 months, it might attract a higher tax liability. Whereas, holding longer attracts lower tax + lets you avail of an exemption. To use the 12.5% LTCG rate to your advantage, you may prefer delaying your exit beyond 12 months.
 

Let’s see through an example how this timing difference could let you save more tax.

Example

Assume that the capital gain is ₹5,00,000. Now, if you sell your units before 12 months (STCG), these gains would be taxed @ 20%. The liability would be ₹1,00,000 (₹1,00,000 x 20%) + applicable surcharge and health and education cess.

In contrast, if you sell after 12 months (LTCG), the first ₹1,25,000 will be exempt. Only the balance ₹3,75,000 (₹5,00,000 - ₹1,25,000) will be taxed @12.5%. The tax liability would be ₹46,875 (₹3,75,000 x 12.5%) + applicable surcharge and health and education cess. 

If we compare the “net capital gain retained”, you held ₹4,53,125 in the case of LTCG and only ₹4,00,000 in the case of STCG. The additional gain retained by merely waiting is ₹53,125. Due to time difference.

So now you know how to use the 12.5% LTCG rate to your advantage. After the income tax changes, gains realised from specified debt mutual funds are treated similarly to “fixed deposit income”. They are 100% taxable at the investor’s income tax slab rate (irrespective of the holding period). This rate can go up to 30%, which significantly increases the tax burden even for long-term debt investors.

In contrast, LTCG from equity oriented mutual funds is taxed at a flat 12.5%, along with an annual exemption of ₹1.25 lakh. This can result in a substantially lower tax liability on the same amount of gains.

Additionally, tax efficiency improves further when equity investments are held for the long term. By staying invested beyond 12 months, you can shift from a 20% STCG tax to the lower LTCG rate of 12.5% with an exemption. Want to estimate your tax impact accurately? You can even use an online LTCG calculator and plan your redemptions accordingly.

The views mentioned above are for information & educational purposes only and do not construe to be any investment, legal, or taxation advice. Investors must do their own research before investing. The views expressed in this article are personal in nature and in is no way trying to predict the markets or to time them. Any action taken by you on the basis of the information contained herein is your responsibility alone, and Tata Asset Management Pvt. Ltd. will not be liable in any manner for the consequences of such action taken by you. Please consult your Mutual Fund Distributor before investing. The views expressed in this article may not reflect in the scheme portfolios of Tata Mutual Fund. There are no guaranteed or assured returns under any of the schemes of Tata Mutual Fund.