Churning is contrary to the long-held view that equity investments fetch the best returns if they are held for long periods
Everybody hates taxes and investors are no exception. Many are searching for ways to either avoid or minimise the long-term capital gains (LTCG) tax.
One of the ideas being touted is to churn the investment portfolio annually. But will the selling and buying of shares/units of mutual funds help investors to avoid or reduce their tax outgo? Also, would the amount of taxes saved by the annual churning be worth the trouble in the long run?
It is felt that many brokerage houses may encourage their investors to churn their portfolios to save on taxes. “We are likely to see some churn happening. Many investors will be advised to churn. Especially in the case of mutual funds, investors will be advised to get out of dividend option and choose the growth option,’’ points out P V Subramanyam, chartered accountant and financial trainer.
But experts are unanimous in their view that churning the portfolio, just to save taxes, is not beneficial for investors. The churning strategy is flawed, feels Vidya Bala, head, mutual fund research, FundsIndia. “It focuses on tax paid instead of net returns made. It does not account for the lower overall return by churning and investing,’’ points out Bala.
Incidentally, this strategy of selling and buying again each year to save taxes is contrary to the long-held view that equity investments fetch the best returns if they are held for long periods.
“Unnecessarily churning the investment portfolio is counter-productive. Rather, investors should focus on generating returns out of their portfolios,’’ points out Deven Choksey, promoter, KRChoksey.
“It is a wrong strategy for mutual fund investors as they will lose out on returns,’’ says Bala.
Assuming pre-tax rate of return at 12%, if a corpus of Rs 25 lakh is invested for a period of 10 years and each year the person books profit in such a way that the capital gains is Rs 1 lakh and reinvests the sale proceeds again, then the person would be left with a post-tax corpus of Rs 70.81 lakh. However, if the same person does not churn the portfolio but chooses to remain invested, then they end up with a corpus of Rs 72.27 lakh.
“The investor who chooses to hold ends up with a return of 11.2% while the investor who keeps churning the portfolio will end up with a return of 10.9%,’’ points out Bala.
The tax is higher at Rs 5.37 lakh in the case of the hold strategy and lower at Rs 5.09 lakh in the case where the portfolio follows the churn strategy. But do not get carried away by the lower taxes.
Remember, the lower taxes is due to the lower gains.
The reason the taxes are higher if one holds for a longer period is because you are paying tax on a larger amount as the gains are higher.
One ends up paying lower taxes in cases where the portfolio is churned constantly. “But that is because you have a lower corpus, thanks to the churning,’’ explains Bala.
One needs to look at the net returns on the portfolio, rather than look at tax outflows alone. “One should take a holistic view. What’s the point if one is left with less money in hand?” asks Bala.
The reason for the lower returns is that by making constant changes to the investment portfolio, investors lose the advantage of starting from a low base. “The investor loses out on the benefit of compounding and buying at a low NAV (net asset value),’’ says Bala.
“The churning strategy may not work for mutual fund investors but it could work for those investing in stocks. However, even that is theoretically possible only if one buys stocks at a lower level each time,’’ says Bala.
In order to buy stocks at low prices, one would have to do a lot of research, which is not possible for the common retail investors. Also, investors need to bear in mind that churning the portfolio annually would involve a lot of paperwork and effort.
Firstly, one would need to calculate the tax outgo and sell the assets in such a way that the LTCG works out to about Rs 1 lakh or so. Then, one has to reinvest the amount into assets for the second year. All this would require a lot of research and paperwork.
The amount of tax saved may just not be worth the effort, especially since the tax saved is at the cost of earnings.
WHAT THE MATH SHOWS
- Churning is contrary to the long-held view that equity investments fetch the best returns if they are held for long periods
- If Rs 25 lakh is invested for 10 years, assuming a pre-tax return of 12%, the investor who chooses to hold ends up with a return of 11.2% while the investor who keeps churning the portfolio will get 10.9% return
- The reason for the lower returns is that by making constant changes to investment portfolio, investors lose the advantage of starting from a low base
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