How does the tax on long and short term capital gains work for SIPs

Tax implications play a pivotal role in the investment journey, particularly when it comes to Systematic Investment plans (SIPs).

SIPs are a popular method of investing in mutual funds, known for their disciplined and gradual approach. Understanding the tax treatment of gains realised through SIPs, categorised as either long-term or short-term capital gains, is essential for investors to make informed financial decisions.

The tax treatment of SIPs encourages investors to adopt a long-term perspective, promoting stability and reducing the tax burden on gains earned over extended periods.

Delving deeper into the intricacies of long and short-term capital gains in the context of SIPs can empower investors to develop more effective and tax-efficient investment strategies. In this concise guide, we break down the essentials for you:

Differentiating Long-Term and Short-Term Capital Gains:

Short-Term Capital Gains (STCG):

When you redeem your SIP investment within three years from the investment date, any profits generated fall under the category of short-term capital gains (STCG).

These gains are subject to higher tax rates compared to long-term capital gains. The specific tax rate varies based on your jurisdiction’s regulations.

Holding duration is crucial, as crossing the three-year threshold could lead to more favourable tax treatment.

STCG is an important consideration for investors aiming to optimise their returns while managing their tax liabilities effectively.

Long-Term Capital Gains (LTCG):

When you retain your SIP (Systematic Investment Plan) units for a period exceeding three years, any profits made upon redeeming them are categorised as long-term capital gains (LTCG).

This classification generally incurs favourable tax treatment, often resulting in lower tax rates compared to short-term gains.

This three-year threshold is a key determinant in tax assessment, encouraging investors to adopt a patient approach and potentially benefit from reduced tax liabilities when they decide to redeem their investment.

Taxation of Short-Term Capital Gains:

STCG gets included in your overall taxable income and is subject to taxation based on your individual income tax slab rates.

The prevailing income tax brackets dictate the rate at which your STCG will be taxed.

Taxation of Long-Term Capital Gains:

LTCG tax only kicks in if the profits exceed Rs. 1 lakh in a financial year.

The applicable tax rate for LTCG is 10% without the benefit of indexation. Indexation adjusts the purchase cost for inflation, which can lower the taxable amount.

FIFO Method and Taxation:

The “First In, First Out” (FIFO) method determines which units are considered sold first when you redeem Systematic Investment Plan investments.

This method can affect your tax liability. Selling units from the earliest purchases (first in) may lead to a lower STCG if you’ve held them for a shorter duration.

Conversely, selling the most recently purchased units (last in) might result in LTCG treatment, leading to potential benefits like indexation.

FIFO Method Example:

Year 1: 200 units at Rs. 50 each

Year 2: 150 units at Rs. 60 each

Year 3: 100 units at Rs. 70 each

Now, after holding onto your units for a period of five years, you decide to redeem 300 units. To calculate the LTCG using the FIFO method:

You’ll first sell the 200 units purchased in Year 1. If the current market value is Rs. 80 per unit, your profit per unit is Rs. 30 (Rs. 80 minus Rs. 50).

The total LTCG from selling these units will be 200 units x Rs. 30 = Rs. 6,000.

Since you’re selling units held for more than three years, this qualifies as a Long-Term Capital Gain.

According to the current tax regulations, the LTCG tax is 10% without the benefit of indexation. In this case, you would be required to pay a tax of 10% on the LTCG of Rs. 6,000, which amounts to Rs. 600.

Remember, the FIFO method ensures that you sell the earliest purchased units first, which in this example led to a Long-Term Capital Gain with associated tax implications.

Tax Implications of Investing via SIP and Redeeming as a Lump Sum:

Investing through SIPs has tax implications during lump-sum redemption. The period of holding dictates tax treatment, distinguishing gains as short-term or long-term.

If SIP units are held for over three years, the resulting gains are considered long-term and are often taxed at more favourable rates.

Conversely, holding for under three years leads to short-term gains with higher taxes. Thus, the duration of investment significantly influences the tax impact upon redeeming SIP units in a lump sum.

Considerations for Effective Tax Planning in terms of SIPs.

Effective tax planning within the context of Systematic Investment Plans (SIPs) is vital for optimising investment returns while minimising tax liabilities. Here are key considerations to enhance your tax planning when using SIPs:

Holding Period Strategy: Plan your SIP investments with a long-term perspective. Holding investments for more than the stipulated threshold (usually one year) can result in more favourable long-term capital gains tax rates. 

Asset Allocation: Choose SIP funds that align with your tax goals. Equity-oriented funds may offer tax advantages due to their potential for long-term gains and the availability of tax exemptions on dividends and capital gains.

Tax-Loss Harvesting: In case of underperforming SIPs, consider redeeming them strategically to offset gains with capital losses, thereby reducing your overall tax liability.

Redemption Timing: Be strategic in redeeming SIP units. If nearing the long-term capital gains threshold, waiting a bit longer might lead to reduced tax liabilities on the gains.

Tax-Efficient Funds: Consider investing in funds that have historically demonstrated tax efficiencies, such as funds with a buy-and-hold strategy, minimising turnover and potential short-term capital gains.

Record-Keeping: Keeping precise records of your systematic investment plan investments, including dates, units, and amounts, is essential for accurate tax calculations at the time of redemption.

Conclusion

In summary, SIPs offer a disciplined approach to investing, but understanding the tax implications is paramount.

Differentiating between short-term and long-term capital gains, implementing the FIFO method, and being mindful of the tax consequences of transitioning from SIP to lump sum redemption is critical for informed decision-making.

Engaging with financial advisors or tax professionals can provide personalised guidance tailored to your unique financial situation and objectives.

Reference: https://economictimes.indiatimes.com/wealth/tax/how-to-calculate-long-term-capital-gains-tax-on-mutual-fund-sips/articleshow/63697072.cms?from=mdr