You have been eyeing various investment options to grow your money smartly while keeping taxes in check. When exploring the available options, ETFs have caught your attention. Not only are they convenient and cost-effective, but they also come with attractive tax advantages that could positively impact your financial strategy. Let’s dive deeper into how investing in ETFs can offer you significant tax benefits.
What are Exchange-traded Funds?
ETFs or Exchange Traded Funds are investment schemes that trade on stock exchanges comparable to individual stocks. They pool money from various investors to invest in a broad portfolio of assets, such as stocks, bonds, or commodities. When investing in an ETF, you own a share representing a portion of the fund’s holdings.
ETFs mirror the performance of a specific index, sector, or asset class.
How Do Exchange-Traded Funds Work?
To understand this in simple terms, let’s take an example.
Imagine a fund manager is given ₹1,000 and asked to create an ETF that tracks the Nifty 50 index. Now, assuming HDFC Bank has a 12% weightage in the Nifty 50, Reliance has 8.5%, and ICICI Bank has 8%,
To replicate this, the ETF would invest ₹120 in HDFC Bank stocks, ₹85 in Reliance, and ₹80 in ICICI Bank.
Understanding Different ETFs and Their Taxation
ETFs are taxed based on their underlying assets. Here are the details.
Equity Oriented ETFs
Earnings from equity-oriented ETFs are considered capital gains and are taxed based on your holding period. For example, if you hold the investment for up to one year, the gains will be considered short-term capital gains. They are considered long-term capital gains if the holding period is more than one year.
- According to Section 112A of the Income Tax Act, if you made long-term capital gains over ₹1.25 lakhs and redeemed your holdings on or after 23rd July 2024, the income will be taxed 12.5%. If you sold your holdings before this date, the tax rate is 10% on the amount exceeding ₹1 lakh.
- According to section 111A of the Income Tax Act, any short-term capital gains you made by selling your holdings on or after 23rd July 2024, the income will be taxed at a rate of 20%. If you sold your holdings before this date, the tax rate is 15%.
Dividend Income from Equity-Oriented ETFs
Before 2021, your income earned through dividends was subject to a dividend distribution tax (DDT) of 15%. However, the government has abolished this tax, and any dividend income from ETFs is now added to your annual earnings and taxed according to your income slab.
Any Other ETFs
Whether you are investing in debt, gold, international, or any other ETFs, all these assets are now categorised as short-term capital assets. Their income will be added to your annual earnings and taxed according to the income tax slab rates.
The government implemented these changes through an amendment to the Finance Bill issued on 1st April 2023.
Step Guide to Investing in ETFs
You can invest in ETFs by adhering to the steps below.
- Step 1: Research ETFs that align with your investment goals and risk tolerance. Consider factors such as expense ratios, asset classes, and historical performance.
- Step 2: Select a brokerage platform that offers access to the ETFs you are interested in. Compare trading fees, platform usability, and research tools.
- Step 3: Open Demat Account by providing the necessary KYC documents and funding for your account.
- Step 4: Use the brokerage platform to place buy or sell orders for the chosen ETFs. Specify the quantity and order type (market or limit).
- Step 5: Keep track of your ETF holdings and market performance. Consider setting up alerts for price movements or news affecting your investments.
- Step 6: Review your ETF portfolio regularly to ensure it meets your financial objectives. Adjust holdings if necessary based on market conditions or changes in your investment strategy.
What are the Risks Associated With ETF Investment?
Since the ETF returns are linked to the market, they carry certain risks in the following form.
- Market Volatility: ETFs track indexes or sectors, so they are affected by market swings. Rapid price changes can unpredictably impact an investment’s value.
- Liquidity Risks: Some ETFs may trade infrequently, leading to wider bid-ask spreads. This could affect your ability to buy or sell at desired prices.
- Tracking Error: ETFs aim to mirror an index’s performance, but factors like fees or trading differences can cause slight deviations from that performance.
- Sector Concentration: Certain ETFs focus heavily on specific sectors or industries. If that sector underperforms, your investment could suffer.
- Currency Risk: If you invest in foreign ETFs through your Demat Account, fluctuations in exchange rates can impact your returns when you convert back to your currency.
- Counterparty Risk: Synthetic ETFs use derivatives. The counterparty (issuer) may not fulfil obligations, affecting the ETF’s value.
ETFs vs. Mutual Funds: What’s the Difference?
While ETFs and mutual funds share similarities, they differ in several aspects:
Feature | ETFs | Mutual Funds |
Trading | Traded on stock exchanges | Bought/sold via AMC |
Pricing | Real-time market prices | End-of-day NAV |
Management | Passively managed | Actively or passively managed |
Expense Ratio | Lower | Higher |
Liquidity | High (on exchanges) | Moderate |
Conclusion
ETFs offer a unique blend of simplicity, diversification, and tax efficiency, making them a compelling choice for modern investors. Understanding the taxation rules allows you to maximise your returns while complying with tax regulations. Their cost-effectiveness, potential long-term capital gains benefits, and streamlined dividend taxation enhance their appeal. However, staying informed about risks like market volatility and tracking errors is essential.
With proper planning and regular review, ETFs can be valuable additions to your investment portfolio. They can align with your financial goals and tax-saving strategies.