Tax Efficient Investment options for Short-Term Financial Goals

Now that there are no major changes to mutual fund taxation in budget 2015, let us take a look at the investment options available for short-term goals.

First let me take a swipe at Value Research online. On 5th Feb. 2015, it reported that "According to a person familiar with the development ... the forthcoming budget is likely to term these funds as debt funds for the purpose of taxation".

When this news was posted at Facebook group Asan Ideas for Wealth, Dr. Uma Shashikant promptly reminded us that the Fin Min goes into lockdown after a halwa party.

There is no mention of arbitrage mutual funds in the finance bill.  Meaning the status quo continues: they will be taxed like equity mutual funds. There is no reason for VR online to post such articles other than to generate traffic.

Now, what are the requirement of a short-term goal. That is a goal equal to or less than 5 years away.

1) Inflation will have  an influence, but one cannot run after inflation beating returns because that implies choosing volatile instruments like equity.

2) Preservation of capital is the number one priority. If there is a loss, there is not enough time to make up for it.

3) Tax efficiency is only a  distant second priority.

4) Returns is not a priority.

5) I would say comfort level is a priority but some nutters out there would choose (and recommend) sector funds for short durations, because 'they are comfortable with it'!

If you have a history of using fixed deposits and recurring deposits for short-term goals, good for you. There is no flaming hurry to switch to mutual funds.  Read no further.

If you are in the 10% or 20% slab, used fixed and recurring deposits alone, irrespective of interest rates. Read no further.

If you are planning for important short-term goals for the first time, used fixed and recurring deposits alone, irrespective of tax-slab. Read no further.

Pay a little tax. It won't kill you.

Now, let us look at other options.

Debt mutual funds.

Choose only two categories: Liquid funds and ultra-short-term funds. Nothing else. This way, you minimize (if not eliminate) interest rate risk.

Use only those funds which invest predominantly in bank and PSU certificate of deposits. This way, you minimize (if not eliminate) credit risk.

Mode of investment:

1) Growth option will be taxed as per slab for units which are less than 3Y old.

2) Beyond that they will be taxed at 20% (+cess) with indexation.

For those in the 10% and 20% slabs (if they wish to use mutual funds - they need not), it makes sense to use growth option for all durations.  If they are going to withdraw money from time to time, then it makes all the more sense to use debt mutual funds, since they will have to pay tax only upon redemption, unlike bank deposits in which gains are taxed each financial year.

For those in the 30% slab, growth option for goals more than 3Y away. Remember though that in a SIP the unit age of each installment has to be considered for taxation.

For less that 3Y, they (in 30% slab) could consider the weekly or monthly dividend reinvestment option in liquid funds (other categories are not regular with their dividends).

In this case, units will always be purchased and sold at NAV = 10 per unit (ideally). This means capital gains will be minimized (if not eliminated).

Growth in this case occurs only via accumulation of units. However, it must be kept in mind that dividends in non -equity mutual funds suffer a dividend distribution tax (current rate 28.840%). While this is still better than paying 30.9% tax, it is not optimal.

Arbitrage and Equity savings mutual funds

If you wish to know about how arbitrage funds work, see this

Do not use arbitrage or the new category, equity savings funds  for goals less than 1Y away in the hope paying lesser tax (15%+cess). Arbitrage funds have given negative returns over a month and are risky when used for short durations. 

If you need money in just a few months time, use fixed deposits or liquid funds only.

Arbitrage funds have a monthly dividend reinvestment plan. The dividends in this case are tax-free. So this efficiently minimize short-term capital gains compared to debt funds.

However, besides small but non-zero risk of capital loss, dividends in this case are not regular. See an example here.

Debt oriented balanced funds

Also known as monthly income plans, they can be considered for a 5Y duration but bear in mind that risks here are considerably higher since there is about 10-15% of equity in the folio and the bonds may carry interest rate and credit risk.

This is a reasonable option for goals which are less important and bit flexible.

Equity oriented balanced funds and other equity funds

Anyone who recommends these for short-term goals is clueless about risk. Stay away.

Short-term goal planning is not an important element of financial planning. Keep it as simple as possible, even if that means paying some tax.

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12 thoughts on “Tax Efficient Investment options for Short-Term Financial Goals

  1. Anand

    Thanks Pattu. Somehow, from a 'personal finance' perspective, im yet to get a handle on this whole stuff of the debt MFs side of investing. Seems like, the whole thing is setup for situations involving large capital in short terms - which, probably is never the case for individual investors.

    And taking a cue from all what you have written so far, I would rather prefer having a bucket like strategy (and more so, in terms of thinking and planning for known goals long before they actually become short term).

    Reply
  2. Anand

    Thanks Pattu. Somehow, from a 'personal finance' perspective, im yet to get a handle on this whole stuff of the debt MFs side of investing. Seems like, the whole thing is setup for situations involving large capital in short terms - which, probably is never the case for individual investors.

    And taking a cue from all what you have written so far, I would rather prefer having a bucket like strategy (and more so, in terms of thinking and planning for known goals long before they actually become short term).

    Reply
  3. JD

    I have put some amount in liquid fund as emergency fund. Age is arround 3 Yrs now. If today i need those money and how i will be taxed upon removal from the same? I had put in HDFC Liquid fund Growth Option. I am an NRI.
    Please suggest to best tax efficient way currently available for keeping emergency fund.

    Should i keep it in the same fund and continue if money not required currently? or should i redeem and put it other way?

    Thanks & Regards,

    Reply
    1. freefincal

      If the units are older than 3Y, you will be taxed with indexation at 20% +cess. In case of NRI there maybe TDS. you will have to confirm. For NRIs tax free FDs is enough for emergency funds.

      Reply
  4. JD

    I have put some amount in liquid fund as emergency fund. Age is arround 3 Yrs now. If today i need those money and how i will be taxed upon removal from the same? I had put in HDFC Liquid fund Growth Option. I am an NRI.
    Please suggest to best tax efficient way currently available for keeping emergency fund.

    Should i keep it in the same fund and continue if money not required currently? or should i redeem and put it other way?

    Thanks & Regards,

    Reply
    1. freefincal

      If the units are older than 3Y, you will be taxed with indexation at 20% +cess. In case of NRI there maybe TDS. you will have to confirm. For NRIs tax free FDs is enough for emergency funds.

      Reply

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