Taxes that eats your Investment Returns

Table of Contents

With the rate on modest savings and deposits decreasing year after year, investors have the option of investing their hard-earned money in the stock market and earning a higher return. However, investing in the stock market has risks and taxes that reduce your earnings.

For stock investments, our tax rules provide for two types of capital gains taxes. If you keep an equity investment for less than one year, any profits are subject to 15% taxation. This is referred to as the Short Term Capital Gains Tax (STCG). If you maintain an equity investment for more than one year, you will be subject to a 10% tax on any profits. This is referred to as the Long Term Capital Gains Tax (LTCG). Furthermore, up to Rs 1 lakh of LTCG is tax-free in any given financial year, resulting in LTCG tax savings of up to Rs 10,000. Finally, not every investment opportunity is the same.

Various Taxes that affect your Earnings from Stock Markets

  1. Dividend Tax
  2. Stocks
  3. Bonds
  4. REITs
  5. Mutual Funds
  6. ETFs
  7. Fully Taxable Investment 

1. The Dividend Tax Break

If we assume that this entire return came from dividends (rather than capital gains), then the basic-rate taxpayer would pay no tax on this and earns the full 5.29% a year. The higher-rate and top-rate taxpayers earn 3.03% and 2.35%.

All taxpayers make money in real terms, but those in higher tax bands still end up with a good deal less than the headline return might suggest.

2. Stocks

Dividend distributions you receive from stocks are usually taxable, and the rate varies depending on the type of dividend:

  • Nonqualified dividends are taxed at your ordinary income tax rate.
  • Qualified dividends are taxed at a lower rate based on your taxable income and filing status and capped at 20 percent.1 Factors that determine whether a dividend is qualified are the time you’ve owned the stock, country of origin and the type of distribution received.

If you sell your shares, you’re taxed on capital gains. The capital gains rate varies based on how long you’ve held the stock:

  • With stocks held for less than a year, you’ll pay a short-term capital gains rate that is generally the same as your ordinary income tax rate.
  • With stocks held for more than a year, you’ll incur a long-term capital gains rate that is based on your income bracket and capped at 20 percent.2

3. Bonds

Interest earned on bonds is taxed as ordinary income.

4. REITs

Real estate investment trusts (REITs) allow investors to earn returns on bundled pools of real estate investments. REIT distributions are taxed as ordinary income, but gains are taxed at the capital gains tax rate.

5. Mutual Funds

Because mutual funds are made up of different investment securities, such as stocks and bonds, dividends and capital gains are based on how long a fund has held an individual investment in its portfolio rather than on how long you’ve owned shares of the mutual fund.

Mutual funds will generally pay distribution on accrued income whether dividend or interest, in the form of dividends. They may also pay a distribution for the capital gains incurred within the vehicle. These are taxed depending on type of investments that make up the mutual fund and the qualifications of the investment account and the investor. When you sell your position, you’ll be taxed on the capital gains accrued in your holding.

6. ETFs

Exchange-traded funds (ETFs) act similarly to mutual funds when it comes to taxes, but distributions are only accrued on dividend/interest income and not on capital gains due to way they’re structured. This can make some ETFs more tax-efficient than mutual funds.

7. Fully Taxable Investment 

These investment vehicles do not receive preferential tax treatment. You will pay taxes on the income you earn through interest, dividend distributions or capital gains. However, there are no limits on how much you can invest.

How to Do Damage Control

For equities investments, our tax code provides for two types of capital gains taxes. If you keep an equity investment for less than a year, any profits are subject to 15% taxation. Short-Term Capital Gains Tax (STCGT) is the term for this type of tax (STCG). If you maintain an equity investment for more than a year, all profits are subject to a 10% tax. Long-Term Capital Gains Tax (LTCGT) is the term for this (LTCG). Furthermore, up to Rs 1 lakh of LTCG is tax-free in any given financial year, resulting in a tax savings of up to Rs 10,000. Finally, not every investment opportunity is equal.

The second method is a bit more daring. It tries to predict which funds or equities will do well and rebalances every year after one year to avoid the higher 15% STCG tax charge. Every year, this technique effectively pays the 10% LTCG tax. Which approach will outperform the other over the next 20 years if both have 12 percent annual returns? Most investors believe they will follow suit. After all, what difference does it make whether you pay 10% LTCG tax once after 20 years of compounding or every year for 20 years if the compounding rate (12%) is the same?

The third strategy is considerably more ambitious. It’s a stock-by-stock themed basket approach that churns numerous times a year, thereby paying the entire 15% STCG tax on all profits. To break even with a basic index buy and hold strategy on a post-tax basis, such a strategy would have to yield 2-2.5 percent extra gains per year. While many thematic and PMS fund managers claim excess returns of 2.5 percent or more based on spurious backtests or other claims, I’ll leave you with a simple reality. Only a few investors and funds in the lengthy history of global stock investments have achieved excess returns of 2.5 percent or more over a 20-year period.

4 Costs that eat into Investment Returns

1. Lowest Price

Any expenditure that has already been incurred but cannot be recovered is referred to as this. Such a cost might be incurred by both businesses and individuals. Let’s say you pay a consultant Rs 1,000 for advice. The money has now been spent, regardless of whether you take the advise. Sunk cost is the term used to describe this situation. Another example is the cost of market-entry research, which occurs when a corporation undertakes a study to determine the possibility for entrance into a new market. However, this sunk cost is frequently misinterpreted. The sunk-cost fallacy is what it’s referred to as. This occurs when you invest in a losing asset and refuse to depart or stop investing in order to justify your efforts.

2. Cost of Opportunity

Money may be put to many different uses, some of which are more profitable than others. You may use opportunity cost to determine which option is more profitable. Simply put, it’s the profit you’re foregoing by putting the funds in another asset. Otherwise, you’ll be losing out on a better opportunity to earn more money. When you calculate opportunity cost, you’re simply comparing the prospective returns of both alternatives. When considering alternative initiatives for investment, companies often evaluate the opportunity cost.

3. Capital Cost

You may borrow money to invest whether you are a firm or a person. This might take the shape of margin money or a loan for an individual. Companies obtain financing via issuing bonds, debentures, or taking out a bank loan. In any case, borrowing has a cost – the interest you must pay out of pocket. As a result, it reduces your overall earnings. Companies must account for the proportion of money obtained through debt and cost of equity, then average the cost based on the weightage. WACC stands for Weighted Average Cost of Capital (WACC).

4. Return on Investment (ROI)

All of a company’s profits are frequently re-invested. They do not share their profits with their stockholders. Retained profits are the term for this. ‘Growth options,’ in contrast to high-dividend-yield firms, are referred to as such. Profits that are re-invested might result in further growth. After all, it’s a less expensive and interest-free alternative to borrowing. You, the investor, will, however, pay a price. ‘Cost of Retained Earnings’ is the term used to describe this. This is the profit you would have made if you had taken the dividend money and reinvested it.