Readers may recall that I have been covering equity LTCG tax in a series of posts. First, the implications, followed by simple examples on how to calculate LTCG tax after accounting for the grandfather rule. Then we discussed an illustration of how much Equity LTCG tax we need to pay. Now, in the second part of the illustration let us consider a question on many minds: should I book profits each year (up to the tax-free limit of one lakh) to lower Equity LTCG tax?
Why are investors considering booking profits each year? How does it lower Equity LTCG tax?
Let me give an example to make this clear. Please note if you to save tax or get returns, you need to focus and learn certain aspects of equity investing and taxation (in this case).
Let us start with this simple example:
Suppose you invest Rs. 10,000 in a mutual fund or stock at a NAV of Rs. 1/unit (assume this investment is made on or after February 1st, 2018 so no Jan 31st confusion).
So you get 10,000 units. After one year, the NAV = 2 per unit. So your portfolio value = 20,000.
The capital gain(CG) = no of units (current price – buying price) = 10000 x (2-1) = 10,000
Now, you decide to redeem 5000 units at a price of 2 and immediately buy it back (not practical, but hey anything works in Excel!).
Units are redeemed on a first-in and first-out basis. As of now, all the 10,000 units were purchased at the same time, so no problem.
You redeem 5000 x 2 = 10,000 and buy it back. We will call this profit-booking or resetting.
After one year the Nav = 3 per unit. (real life volatility will make a big difference to booking profits).
Suppose you had NOT booked profits (no reset),
CG = 10,000 X ( 3-1) = 20,000
Because you did a reset,
CG(reset) = 5000 x (3-1) + 5000 x(3-2). Do not move forward until you understand this!!
5000 units which were redeemed at NaV = 2 and reinvested at NAV =2 will have a CG = 5000 x (3-2).
Wheres the untouched units have a CG = 5000 x (3-1).
CG(reset) = 10,000+5000 = 15,000.
Now the NAV = 3. Total units = 10,000.
Your CG(reset) is 15,000. You redeem this at NAV =3 and reinvest at NAV =3 (2nd reset).
After one more year, the NAV = 4
CG(no reset) = 10000 x (4-1) = 30,000
CG(with reset) = 5000 x(4-3) + 5000 x (4-2). Why? Again do not move forward until you understand!
Redemption is on first-in, first-out basis. When you did the second rest, you pulled out the oldest 5000 units (purchased at Nav =1 per unit) and repurchased at Nav =3.
So for these units the CG(reset) = 5000 x (4-3). Now there are an additional 5000 units purchased at NAV =2 during the first reset. For this the CG(reset) = 5000 x (4-2)
So in total, CG(with reset) = 5000 x(4-3) + 5000 x (4-2). = 5000 + 10000 = 15,000
With first reset, the effective CG was lower by 5000. After the second reset, it is now lower by 15000. Again, don’t get too excited. Patience is a virtuosity.
This is the summary of what we have discussed above. Again, take your time and take it in.
The 3750 units in year 3 are only for year 4 CG calculation, so don’t worry about it.
If you are ready for the big picture, let us get to it.
Please note, I have only considered a single lump sum investment made on or after February 1st 2018. So no grandfathering business.
Equity LTCG Tax: Illustration 1 (no volatility)
After 13 years of this resetting gymnastics, we have saved a grand sum of Rs. 3,120. Yay! we are so smart! This benefit is the same as refusing to surrender a policy and making it paid up and getting the accrued bonus which will stay dormant after many years.
Okay, so the NAV growth assumed above was nice and straight. Let us add some volatility and see what happens.
Equity LTCG Tax: Illustration 2 (10K investment + volatility)
Let us try this price sequence.
So now, we have a saving of 11,463 after 13 years. Many new investors with small portfolios and not aware of market swings are likely to call this “a big amount”. Well, some things have to be experienced and cannot be explained in words. If you think this is a great saving, then I wish that you soon become a crorepati lose or gains lakhs in the market on a daily basis. Then you will recognise this “saving” is peanuts. It is a rite to a passage that must be experienced. So do not listen to me.
Now let us increase the investment 10K –> 1 Lakh —> 5 Lakh —> 10 Lakh —> 25 Lakh for the same volatility sequence.
Equity LTCG Tax: Illustration 2a (1 Lakh investment)
Notice how much the tax difference has reduced! Keep an eye on that below. As your portfolio grows, it is a waste of time in trying to figure out how much you redeem because the reward per year will be comparable or smaller to daily market gains or losses!
Equity LTCG Tax: Illustration 2b (5 Lakh investment)
Equity LTCG Tax: Illustration 2c (10 Lakh investment)
Equity LTCG Tax: Illustration 2d (25 Lakh investment)
Like I said, notice the tax rate difference as the money at stake increases! Let us get rich soon people!
Equity LTCG Tax: Illustration 3(1Lakh investment)
Now let us try this price sequence (these are real Sensex annual movements) with a one lakh investment.
Notice the losses. No resetting was done when there were losses.
Equity LTCG Tax: Illustration 3a(1Lakh investment)
Moral: When the market is rocky and annual (FY) losses are large, you do not reset often (the irony!) the gain from resetting is significant.
The situation is the same with timing the market: volatility will always be reduced but higher returns depend on the price sequence.
In this resetting will always reduce capital gains, but when the market zooms up, the effort does not provide a commensurate reward. If the market is rocky then yes, it has its rewards.
Before you assume resetting is “good”, ask yourself, “over the long term” and all that sort of nonsense, do you expect (read want) the market to move up or move up and down!!
Please do not extrapolate this simple study to your portfolio. You will have many instruments and invest multiple times a year. And if you have been investing for a few years now, the 31st Jan grandfather rule will reduce your losses significantly even if you did not reset. As your portfolio grows in size, the resetting benefit will not amount to much.
It is clear that many investors will reset, but let us at least acknowledge that it is “behavioural” and not “logical”
For the same rocky sequence, consider a 10 lakh investment.
Equity LTCG Tax: Illustration 3b(10Lakh investment)
Notice the drop in the benefits of resetting as you get richer.
Now, you might say, “I am not rich, so I am going to reset”. Then, my friend, I say to you, “You may not be rich today, Good luck”.
I now eagerly await your brickbats.
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