When you buy a mutual fund and sell it after some time, you will pay some tax. This tax is called ‘Capital Gains Tax’. However, there are some completely unintended actions of yours which could lead to a huge (really huge) tax burden! This is WITHOUT selling your mutual fund units. Well, technically your funds went from one scheme to another, but you did not sell.
Tough to understand? I do not blame you at all!
Obfuscation is what happens. Let me enumerate them:
If a couple - say a Husband and Wife are holding the units jointly in a Mutual fund, and on the death of say the second holder, the surviving spouse wants to make it a Joint investment with his children or his sibling, he cannot do it. He cannot change the holding except by redeeming and re-investing. This sounds odd, but it is true. When he redeems and re-invests, he will attract capital gains tax. This does not happen in a bank fixed deposit - if you wish to add a second or third holder there will be no tax implication.
If a unit holder in a mutual fund wants to leave his mutual fund investments equally to his 2 children, he will have to create 2 folios! If one child gets everything, he/she will have to redeem and give the cash to the other kid. What if he wanted to create 2 folios - with each child holding half his units? Both these options will involve taxation.
If an investor shifts from investing through a distributor to ‘direct’, he/she will save a lot of management fees going forward. Is it a good thing to do? Yes, but hey, that does not come free. Be ready to pay Income tax on that transaction - I am sure the law does not intend that, but as of now, that is the law.
If an investor withdraws from a poorly performing fund to invest in a well performing fund - there is no cash available to pay the tax! However he can re-invest only 90% as he/she will have to pay Long Term Capital Gains!
The provision in respect of Real Estate is very different. If you sell Real Estate - the tax can be dramatically reduced - to even NIL by buying another real estate. Not true for gold, mutual funds, or bonds or direct equities. As of now, if you change asset classes (other than RE) be willing to pay Income tax.
Even capital gains needs a lot of rationalising - bringing Real Estate, Gold, Mutual funds, bonds, Equities, etc. taxed in a similar way. Thus what is long-term, how much rate, will it have indexing, etc. - should be uniform. Of course all that is far beyond the scope of this article.
This article is just a warning - before you make a change in folio, method of holding, changing of second holder or third holder, be careful. You cannot reverse a transaction and say ‘there should be no tax’. So please consult a mutual fund adviser and or a Chartered accountant before you do the transaction. Crying over spilt milk is of no use, caveat emptor!
Writes at www.subramoney.com and has authored the best seller ‘Retire Rich - Invest C 40 a day’