Play the field till you get it right

The new capital gains tax norm has brought equity-oriented mutual fund schemes more or less on par with insurance products. One of the advantages that unit-linked policyholders of insurance companies enjoyed over that of mutual funds, till recently, was the flexibility in tweaking the investment portfolio.

For instance, if an insurance policyholder felt that his equity composition needed to be changed on the higher side, he could tell the insurance company to do this.

Most insurance companies allow free switches up to a certain limit during a single year. Here, there is absolutely no tax implication for making such portfolio switches for an investor.

In case of mutual funds, the tax scenario, till recently, was different for equity-oriented schemes (50% or more of equity investments). A mutual fund investor, if he wanted to switch from, say, a balanced fund to a diversified equity fund, for tax purposes, it was considered a sale of balanced fund scheme and reinvestment into an equity fund.

Accordingly, capital gains taxes were levied on any gains made in the process. If the sale had been made within a year of purchase, the marginal rate of tax applied on the capital gains.

And if the funds were sold after holding for more than one year, the long-term capital gains tax of 10% without indexation or 20% with indexation applied. In short, while the insurance policyholder freely made switches to suit his current risk appetite, the mutual fund investor did so only after paying tax.

But post-October 1, '04, the tax scenario has changed for mutual fund investors. According to the new taxation norms, no capital gains would be levied if the equity-oriented schemes (50% or more of equity investments) were sold after being held for more than a year.

In other words, the tax implication for switching between equity-oriented funds is literally nil. But note that if the units were sold within a year of buying, a short-term capital gains tax of 10% would be applicable.

Mutual fund experts feel the current scenario is the ideal time to carry out a revamp of the fund portfolio. In other words, if your mutual fund portfolio has non-performers, probably, this could be the time to prune the portfolio. The advantage is that you can do this with limited tax implications.

Setting off of losses and gains for MFs: Short-term capital losses are those that occur when the investment of the mutual fund is sold before a period of one year from the date of purchase. When the sale or purchase is after a period of one year, the loss would be classified as a long-term capital loss.

The good news is that short-term losses would continue to be allowed to be set-off against long-term as well as short-term gains.

Portfolio rebalancing or pruning is considered by mutual funds experts to be a good investment habit. In fact, taking into consideration one's risk appetite, one has to rebalance one's investment portfolio.

Say, for instance, you are not a high risk-taker and are under 30, then financial consultants probably might advice on a 40% allocation to equity with the rest going into debt-related securities.

But over a period of time, any relative appreciation of equity/debt portfolio, affects the overall debt-equity mixes in your investment portfolio. In this case, if the equity market doubled in the last two years, while debt gave a 10% return in the last two years, you could end up with 55% allocation to equities.

At this point, the risk on your portfolio might not match the risk-taking appetite of an investor and hence, the need to rebalance one's portfolio. While, previously, mutual fund investors had a tough time making such in between switches, today, the new taxation has made their portfolio rebalancing strategy a tad easier.

He could book profits on equity schemes, which he has held on to for more than a year and reinvest into debt funds. Today, there are no tax implications whatsoever.