Last Updated on October 8, 2023 at 1:49 pm
There are times in life when you require money for a need in stages. The most common example is monthly income. Those who do not have much money to play with, cannot take risks and must rely on interest income which is always taxable as per slab. On the other hand, those who have some money to work with can consider investing in instruments where the profit is treated as capital gains. Here are some examples with a calculator to consider the lower tax that will be applicable.
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Even if the capital gains are taxable as per slab or with indexation, partial withdrawals from these can reduce tax when compared to an interest income instrument even for those in the 10% slab.
Note: The illustrations in this post will only apply for partial withdrawals and therefore relevant only under certain circumstances. If you are a retiree, reducing tax should be your very last consideration! The first being is my corpus big enough mutual fund gymnastics. Do not get misled by the crap you read in the media or by sales guys. Do not take risks that you have never taken before in your life. I would strongly advise retirees to test how “big” their portfolio is with the Freefincal Robo Advisory Software Template
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Underlying ideas
1: Profits that are treated as interest income is always added to income and taxable as per slab. Usually, partial withdrawals are not possible, but this does not change the tax rule.
2: Profits that are treated as capital gains can either be taxable or not. We will only consider taxable capital gains in this post, but the logic can easily be extended elsewhere.
3: Partial withdrawals are possible from some instruments with taxable capital gains. Mutual funds that are considered as “non-equity” by the Taxman represent the most common example. Non-equity funds cover all debt funds, gold funds, fund of funds and international funds.
4: In an instrument that offers interest, the principal and interest component can be separated at all times.
5: In an instrument that offer capital gains (or losses), we usually buy units at prevailing market price (or NAV) and sell it prevailing market price. The only constant is the no of units held. We buy units and redeem units. Therefore, when we redeem some of the units held, the amount we receive will contain both the purchase cost (principal) and gain. Such a separation is necessary only for paying tax. This, as we shall below is the reason for lower tax outgo. Read more: Do you know what happens when money is redeemed from a mutual fund?
6: Lower tax is again contextual. If I make a partial withdrawal once a year, then I pay a much lower tax than an interest-based instrument. If I make multiple partial withdrawals, the benefit would be much lower (or even zero, depending on the age of units).
Assumptions
For all the examples below, we will assume that the tax slab is only 5%. Extensions to 20% and 30% slab are trivial and can be done with the calculator below.
The annualized return from the capital gains instrument (say a debt fund) is assumed to be equal to that from an interest-based instrument (say an FD or small savings scheme). In fact, if you play with the calculator, you can see that even if the debt fund offers a higher return, the tax outgo could be lower.
The investment is only a lump sum. A calculator is attached below for systematic investments.
The first partial withdrawal is made after a certain specified duration: 1Y,2Y,3Y,5Y etc.
Example 1: Full withdrawal less than or equal to 3 years
Consider a 1L investment made for 3Y in debt fund (eg.) and a fixed deposit. This is a screenshot from the calculator.
At the end of 3Y (or before 3Y, but not a day after) if entire amount is redeemed from the debt fund, the tax paid will be at slab rate (5%) and will be equal to that paid for the FD.
For 100% withdrawals, this is the case for units with age less than or equal to 3Y.
Example 2: Full withdrawal after 3 years
If full withdrawal is made after 3Y, the person in the 5% slab has to pay 20% tax on the capital gain after accounting for inflation in the purchase price. This is known as indexation.
For example, if the cost inflation index was 1000 during the financial year of purchase and 1100 during the financial year of the redemption (full or partial), then indexed purhase price is given by
(1100 x 1L)/1000.
Here 1L is purchase cost of the units. That is total no of units redeemed x purchase NAV.
So the general formula for indexed purchase price is:
indexed purchase price = CII(final) x Units redeemed x Purchase NAV/CII(initial)
CII(final) = 1100 = cost inflation index in the FY of redemption.
CII(initial) = 1000 = cost inflation index in the FY of purchase.
The indexed capital gain = (redemption amount) – (indexed purchase price)
A flat tax of 20.6% (with cess) is payable on this indexed capital gain regardless of tax slab.
So obviously for those in 5% slab, full withdrawals after 3Y would be a terrible idea!!
Case 1: 5% slab
Notice that
tax paid on capital gains = 271% x tax paid on interest income for 100% withdrawal!!
Case 2: 20% slab
Due to the indexation benefit, a person in the 20% slab will only pay 68% (for the CIII values uses) of the tax paid in an interest-based instrument for withdrawals after 3Y.
Case 3: 30% slab
In this case, the benefit is obviously much higher.
Example 3: Partial withdrawal less than or equal to 3 years
We will only consider the 5% slab below, but the logic is easy to understand and is the same for all tax slabs. If we withdraw 10% of the units held, we will only have to pay 10% of the tax paid in the case of the interest income.
Naturally, lower the no of withdrawals made in a financial year, lower the net tax paid.
Example 4: Partial withdrawal after 3 years
In this case, it depends on the tax slab and the amount was withdrawn. Here is an example of the 5% slab and withdrawal of 10% of units held.
Therefore, for 5% slab
withdrawal of 10% of units held results in only 27% of tax paid in the case of interest income.
withdrawal of 20% of units held results in only 54% of tax paid in the case of interest income.
30% withdrawal ——> 81%
37% withdrawal —->100%
Beyond which partial withdrawals are not beneficial for those in 5% slab.
This is a comparison of all tax slabs
Don’t take the numbers too seriously. They are merely representative of the general idea of partial withdrawals.
Summary
Partial withdrawals (if possible) from instruments with taxable capital gain can be beneficial than paying tax on the total interest from income-based instruments under certain circumstances. I merely wanted to highlight the ideas mentioned in Do you know what happens when money is redeemed from a mutual fund?
Senior citizens should exercise utmost caution before employing the ideas mentioned here. I would recommend using the robo template and/or this post: When should senior citizens purchase an annuity?
Calculators
Download the lump sum capital gains tax vs interest income tax calculator
For multiple investments, use the Mutual Fund Capital Gains Calculator
Disclaimer
Mutual funds are subject to ignorance risks.
Let me know what you think. I hope I have not made a mistake in the above examples!
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