Budget 2018 Impact: Are equity funds still attractive?

While there was much talk about bringing back the Long Term Capital Gains tax on equity instruments, the Union Budget 2018 still managed to surprise us by the way in which it brought it in. Gains from equity instruments held for more than a year, which were tax exempt so far, will now attract a tax of 10%. This comes with an exemption of gains upto Rs. 1 Lakh per year. The imposition of LTCG tax created a lot of noise among investors. So how much should you rethink your investments based on this tax?

Here, we reason out why the introduction of LTCG tax does not take away the potential of equity as a superior long-term asset class.  

Equity as an investment option

Let’s compare investment options. If nothing else, most investors hold fixed deposits. FDs are also the most viable alternative to investments if you were to move out of equity funds. FD interest is taxed at slab rates. Taking past returns and assuming the 10% tax on equity funds, here’s how the two investments stack up.

Based on the average returns generated by diversified funds, if you had invested Rs.5 Lakh  five years ago in an equity fund, it would have grown to Rs. 10.75 lakh after taxes had been paid. The same amount invested in FDs would have grown to just Rs. 6.82 lakhs  after tax. This results in a return differential of approximately 10 percentage points (16.6% versus 6.3%).

FD rates sourced from RBI, tax on FD assumed in highest tax bracket. Returns as of Jan 31st,2018.

Not be to influenced by a specific period returns, we looked at what a SIP in the past 10 years would have delivered compared to a recurring deposit. The example here assumes Rs.5000 was invested monthly in Aditya Birla Sunlife Frontline Equity and an RD at 8% for the last 10 years. The results are very similar to what we saw earlier. An equity SIP was comfortably able to beat an RD even with the ups and downs the market saw in the last 10 years. Other fixed income products such as corporate FDs or PPF may give you slightly more returns than bank FDs, but they still remain way lower in terms of long term returns.

FD rates sourced from RBI, returns as of 31st December,2017.

Looking purely at tax efficiency, equity still has the upper hand. While equity gains will be taxed at 10%,  interest income is taxable at slab rate, which may go as high as 30%. Additionally, gains up to Rs. 1 lakh from equity are exempt while your entire interest income is taxable.

So you see, equity as an investment option retains its strong foothold among other asset classes even with taxes. If you are to get superior returns, you need to be invested in equity as that is the asset class that generates superior returns over the long term.

What changes for you

So the tax imposition doesn’t change the fact that you need equity investments in your portfolio. What it does change is the amount you need to save. Because the tax takes a bite out of your returns, you would need to save a higher amount to reach the same corpus needed for your goal.

Say, you need Rs.20,00,000 after 5 years. Assuming a conservative return of 12%, it works out to an investment of Rs. 24,700 per month. But you will have to pay a capital gains tax of Rs.55,100 (considering the 1 Lakh exemption, it will be Rs.44,700). To make sure your investments don’t fall short of the required amount, you will need to increase your monthly investments to Rs. 25,400 monthly instead, an increase of Rs 700. That basically means that the increase required in your monthly SIPs to reach your goal is not unmanageable.

The easier way to calculate your monthly investment would be to assume post-tax returns. For example, if you assume a 12% annual returns you can discount the return rate by 10% (which is the tax rate) and assume it at 10.8%. This method will give you a close approximation on the amount you will need to invest every month to reach your target amount post tax.

However, eventual tax impact goes down when we take a longer period into consideration. The below table shows pre and post- tax returns from a lumpsum investment for different periods. The divergence between pre and post-tax returns reduces for longer periods. This is because, longer the period, more the money is compounded. And the additional returns you get from that compensates for the tax outgo.

The bottomline? Equity still remains the superior asset class in terms of returns. What you have to do is to step up your investments by a notch to account for this new tax.