Why MFs are Better Investment Option than Stocks?
When it comes to investing both stocks and mutual funds offer potential for significant returns. However, from a tax perspective, mutual funds stand out as a better option. This is especially true after recent changes in tax laws. Understanding these differences can help investors make smarter choices. It can potentially save a lot of money over time.
In recent years, tax on long-term capital gains (LTCG) from stocks and mutual funds has been the point of focus. While the government has reduced tax on property sales, LTCG tax on stocks and mutual funds remains in place. This tax was introduced seven years ago. Since then, it has risen from 10% to the current rate of 12.5%. It is almost a uniform rate applied for most stocks, equity mutual funds, and many other types of investments. Despite the uniformity of tax rates, there are some differences. These differences concern how stocks and mutual funds are taxed.
It can thus be said that one of the major benefits of mutual funds is that they are much more efficient in terms of tax compared to stocks. The case has been that way since February 2018. With the recent hike in LTCG tax, it’s all the more relevant. Many investors may not appreciate this very much. But it’s important to understand how it works.
If you invest in stocks, you will most likely be buying and selling stocks from time to time. Even if you hold most of your stocks for several years, changes in the market, company performance, and other factors may force you to sell some stocks and buy others. Each such transaction may result in a tax liability because you are directly involved in buying and selling.
On the other hand, when you invest in an equity mutual fund, all buying and selling within the fund is done by the fund manager. Since you aren’t directly involved in these transactions, you don’t have to pay taxes on them. This can make a big difference over time. You can retain money that would otherwise have gone into taxes for continuing investments and this will have a compounding effect, which will make a huge difference in your long-term returns.
For example, if you paid a few lakhs in LTCG tax this year, that amount may grow into multiple lakhs over the next five years, if it were otherwise invested. Now, tax savings plus the additional growth of that very investment, combined, could lead to much higher returns in the long run.
Another instance when you would want to buy and sell investments is during asset rebalancing, moving money from equities into fixed income. Hybrid funds that combine both equities and fixed income in one fund are good solutions for this. If the debt-equity ratio of a hybrid fund matches your desired asset allocation then it’s a very stable option and requires minimal selling until you need to redeem your investment.
There is also an interesting option available through the NPS Tier-2 account. This account essentially works like a collection of low-cost mutual funds. It’s available to NPS Tier-1 members. Unlike Tier-1, Tier-2 accounts can be bought and sold like regular mutual funds. The best part is that you can switch your asset allocation in these funds without incurring capital gains tax. If you have an NPS Tier 1 account, it may now be time to reconsider the Tier 2 account as a potential investment opportunity.
Whether you are an experienced or a new investor, the tax implications of investment decisions are very important to be known and understood. Compared to their counterparts in equity, mutual funds provide far greater tax efficiency. This makes them smarter options for long-term wealth building. These benefits can make one make informed decisions that would prove to be very helpful in maximizing the returns on investment.
