Why is it important to understand the tax implications of investing? What are the key tax implications that I need to understand before investing in stocks?

A very important consideration in investing is the tax implication. Tax implications need to be understood at 3 levels viz.

· Tax treatment of earnings (interest / dividends)

· Tax treatment of capital gains (when you sell your investments)

· Special Tax exemptions under the IT Act.

Let us take the first instance. Take an FD/debenture where you earn Rs.1000 as interest and a share where you earn Rs.1000 as dividend for the same amount of investment. In case of the FD/debenture, your post-tax returns will be Rs.700 (1000-30% tax). In the case of dividends, they are tax free in the hands of the receiver so the post-tax returns will be Rs.1000. The 2016-17 Union Budget had imposed a 10% tax on dividends of over Rs.1 million per annum, but that will be a good problem to have. The moral of the story is that equity returns are more tax efficient in the above case.

In the second instance, take the case of your equity shares sold after 1 year and compare it with gold sold after 1 year. In case of equities, it will be treated as long term capital gains and hence will be entirely tax-fee in the hands of the investor. In case of gold, the definition of long-term capital gains is 3 years and not 1 year. Hence any profit made on gold that is sold at the end of 1 year will be taxed at the peak rate of 30%.

To understand the case of exemption, let us take the case of Equity Linked Savings Schemes (ELSS). Investment in an ELSS fund will qualify for tax exemption under Section 80C of the Income Tax Act. Why is this relevant? The answer is it substantially enhances your effective returns. Assume that you invest Rs.15,000 in an ELSS and it grows to Rs.30,000 at the end of 3 years. You will believe that your money has doubled in 3 years but in reality you have done much better. When you invested Rs.15,000/- in the ELSS you get an exemption under Section 80C! That gives you a tax rebate of 30%. So effectively you have invested only Rs.10,500 (15,000-4500) as the 30% of the ELSS investment has come back to you in the form of a tax exemption. Therefore, your investment of Rs.10,500 has grown to Rs.30,000 in 3 years. That means, you money has not just doubled in 3 years. In effective terms your money has trebled. That is why the impact of tax on eventual returns becomes extremely important from an investor’s point of view.