Mutual Funds vs Stocks: Which is a better tax saving investment option: Investing in the stock market or mutual funds can be a great way to create wealth. But have you ever wondered which of these two is better in terms of tax saving? The recent changes in tax laws have made mutual funds a better investment option for many investors. Let us know why investing in mutual funds can prove to be better than investing directly in shares from a tax saving point of view.
what are the tax rules
To understand this issue, let us first talk about long and short term capital gains tax. Long-term capital gains (LTCG) tax is paid on the profits earned from investments that you have held for a long time. Currently, this rate is 12.5% for both listed shares and equity mutual funds. On the other hand, short term capital gains (STCG) tax has to be paid at the rate of 20% on profits earned from short-term investments. Although the tax rate is the same for both shares and equity mutual funds, the difference in the rules related to its implementation can have a big impact on your total returns.
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Hidden tax liabilities in stock trading
When you invest directly in the stocks of companies through the stock market, the responsibility of buying and selling is yours. As companies change and the market fluctuates, you may have to buy and sell some stocks to keep your portfolio profitable. Whenever you sell a stock for a profit, you are liable to pay tax on it. This means that you may have to pay 12.5% tax on that profit in case of long term capital gain (LTCG) and 20% tax in case of short term capital gain (STCG).
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Mutual funds are tax-efficient
In such a situation, the specialty of mutual funds can be very useful for you. In a mutual fund, professional fund managers handle the buying and selling of shares. When they make changes in the holdings of the fund, you get the benefit of better portfolio management, but you do not have any tax liability on that transaction. You have to pay tax only when you redeem or sell your units of the mutual fund.
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Tax savings and the power of compounding
The savings due to reduced tax liability may seem small initially, but it can turn into a substantial amount over time due to the power of compounding. Suppose you save Rs 2 lakh in tax this year because you invested in mutual funds instead of individual stocks. If that money stays invested and grows for five years, it can amount to Rs 5 lakh or more. You are getting this extra amount only because you chose a more tax-efficient investment option.
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Rebalancing without tax worries
Another advantage of mutual funds is that they aid in asset rebalancing. As you grow older or your financial goals change, you may want to move some of your money out of riskier investments like stocks and into safer investments like bonds. If you invest directly in stocks, this will require you to buy and sell again, which will result in a tax liability. But if you do the same through hybrid mutual funds that invest in both stocks and bonds, you can rebalance your portfolio while keeping your tax liability low.
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Use of NPS Tier 2
For those who are part of the National Pension System (NPS), there is an added benefit. NPS Tier 2 accounts contain low-cost mutual funds that you can buy and sell like normal funds. The biggest advantage? You can allocate your investments between different schemes within the Tier 2 account, without paying any capital gains tax. This flexibility can be a great way to manage your investments in a tax-efficient manner.
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Choose the right funds wisely
It is important to note that not all mutual funds are the same when it comes to tax-efficiency. Diversified equity funds invest in a larger range of stocks. So they usually require less frequent trading. This means that such funds have lower tax liabilities. On the other hand, specialized funds, which focus on a particular sector or theme, require more frequent adjustments, which can increase tax liabilities.
Why tax-efficiency is important
Both stocks and mutual funds can be important parts of your investment strategy. But mutual funds often prove to be better in terms of tax-efficiency. Due to the changes in tax laws, it has become important for investors to think about the impact of their tax liability while making investment decisions. If you take a decision after understanding this issue well, you will be able to save your hard-earned money and achieve your goal of wealth creation in the long term.
