Impact of LTCG tax on your portfolio explained

Long Term Capital Gains (LTCG) Tax estimated to reduce annual portfolio return by 0.5 – 0.75% over 20-year

Budget 2018 brought in a 10% LTCG tax for long-term gains above Rs 1 lakh. The tax is effective starting April of 2018 i.e starting FY 18-19.

Since the tax is applicable only for long-term gains above Rs 1 lakh in a given financial year, it makes the impact of LTCG tax on your portfolio path dependent i.e for the same long-term returns the impact of the LTCG tax can be high or low depending on the order of annual returns.

Let us illustrate with a simple example where one invests Rs 10 lakh today to redeem after 10 years.

Scenario 1

A Rs 10 lakh portfolio gains Rs 1 lakh every year for 10 years. Given the 1 lakh LTCG exemption, the investor can harvest the Rs 1 lakh gain every year and not be required to pay any taxes for 10 years. Total portfolio value of Rs 20 lakhs at the end of 10 years.

Scenario 2

The same Rs 10 lakh portfolio has 0 returns for 9 years and then gains Rs 10 lakhs in the 10th year. The investor now must pay 10% tax on Rs 9 lakh in the 10th year. Total portfolio value of Rs 19.1 lakhs at the end of 10 years.

In either case, the pre-tax gains were Rs 10 lakhs but because of the difference in the path in which the gains were made it created a substantial difference in the final portfolio value.

This is called path dependency.

Estimating the LTCG tax impact

If the outcome is path dependent, how does one determine the impact of LTCG tax on the portfolio? For situations like these quants use a technique called Monte Carlo simulation, which essentially runs many such paths and averages over them to identify the potential impact.

We ran a Monte Carlo simulation to calculate the expected impact of LTCG tax over 20 years investment horizon for three investors. We assume that investors completely rebalance their portfolio annually.

Investor 1 invests 50k per year. Over 20 years LTCG tax will reduce portfolio size by 2% to 10% (assuming XIRR range of 5% to 15%)

 

Investor 2 invests Rs 1 lakh a year. Over 20 years LTCG tax will reduce portfolio size by 3% to 13% (assuming XIRR range of 5% to 15%)

Investor 3 invests Rs 5 Lakhs a year. Over 20 years LTCG tax will reduce portfolio size by 5% to 15% (assuming XIRR range of 5% to 15%)

As you can see the impact of LTCG tax is higher for higher rate of return and for higher investment amount. This is to be expected as large returns or large portfolio size make a Rs 1 lakh gain in any financial year more likely.
To conclude:

An average investor (investing between Rs 1 lakh and Rs 5 lakh a year) should reduce his annual portfolio return expectations by almost 0.5- 0.75 percent over a 20-year horizon due to the LTCG tax. In other words, an average investor should reduce his final portfolio expectations by 10- 15 percent over a 20-year horizon under the assumption of annual rebalancing.

Effectively, higher investment or higher returns would lead to higher tax impact. If a 15 percent reduction in final portfolio value sounds bad, do note that it comes with a 15 percent annual return for 20 years. Now, who wouldn’t want that kind of returns!

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This article was initially published by CNBCTV18 in the Views section.

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