When you earn long term capital gain (LTCG), you can avoid paying income tax if you invest the gain in Sec 54EC tax saving bonds.
But another option is to pay the income tax, and invest the balance amount in some other high-yielding avenue.
Which option makes more financial sense? What is better?
In “How to save / avoid Long Term Capital Gain (LTCG) Tax on Sale of a House”, we saw that you can avoid paying any income tax on your LTCG if you invest the amount of the gain in bonds that save you income tax u/s 54EC.
(To know how to calculate LTCG on sale of a house and the resulting income tax liability, please read “Long Term Capital Gains (LTCG) on Sale of a House – Calculation and Income Tax”. To know what is a capital asset, and to understand long term and short term capital gains, please read “Long Term and Short Term Capital Gain – Income Tax Calculation”)
Thus, you can end up saving a tidy 20% of the gain that you would have otherwise paid as income tax.
The return offered by these bonds is very low – it is around 5.75% per year for most of these bonds.
This creates a dilemma: Should you invest in these bonds and save tax, or, should you pay tax and invest the remaining amount in some other instrument or avenue that gives a much higher return?
This is especially important in the current high interest rate scenario, when even bank fixed deposits (FDs) yield around 10% per annum!
So, let’s take an example, and find out which is better!
Let’s say that you have made a long term capital gain of Rs. 10 Lakhs. (This is after taking into consideration indexation benefit).
You have two options: Saving tax by investing in Sec 54EC tax saving bonds, or paying tax and investing the amount somewhere else.
Let’s find out what the financial implication of each option is, and which option proves to be better! Since the lock-in of the bonds is 3 years, we would compare investments for 3 years.
Option 1: Save tax by investing in Sec 54EC tax saving bonds
Since you want to save tax, you invest the entire LTCG amount of Rs. 10 Lakhs in the bonds.
The rate of return is 5.75%. But remember: the interest on these bonds is not tax-free.
Thus, if you fall in the highest tax bracket of 30%, your post-tax return would be 4% per year.
At 4% interest rate, your Rs. 10 Lakhs would grow to Rs. 11,25,675 in 3 years.
Option 2: Pay tax, and invest in a high-yield avenue
The rate of income tax on LTCG is 20%. Thus, on a LTCG of Rs. 10 Lakhs, you pay a tax of Rs. 2 Lakhs, and you are left with a sum of Rs. 8 Lakhs for investment.
Now, you have two investment options: you can invest in a fixed deposit (FD), or you can invest in stocks – either directly or through a mutual fund (MF).
(To compare direct investment in stocks with equity investment using mutual funds, please read “Direct investment in Stocks versus Mutual Funds (MFs)”)
Investing in bank FD
Currently, bank FDs give interest rate as high as 10%. So, this seems like an attractive option!
Again, if you fall in the highest tax slab of 30%, your post-tax return would be 7% per year.
Rs. 8 Lakhs would grow to Rs. 9,80,034 in 3 years if invested at 7%.
Investing in Shares
Investments in stocks give the best returns in the long term. (To know more, please read “Stocks – The winning bet for the long term”)
A 3 year investment in stocks would be a medium term investment. You can expect a return of 12% to 15% on such an investment.
Let’s examine both these cases. Also, please remember that long term capital gain on investment in shares is tax-free. (To understand long term and short term capital gains and their income tax implications, please read “Long Term and Short Term Capital Gain – Income Tax Calculation”)
So, even the post-tax return would be 12% or 15% when you invest in shares.
At 12%, your Rs. 8 Lakhs investment would grow to Rs. 11,23,942. It would grow to Rs. 12,16,700 if you get a return of 15%.
Comparison of the Options
|Option||Instrument||Amount after 3 years|
|1||Section 54EC Bonds||Rs. 11,25,675|
|2a||Fixed Deposit (FD)||Rs. 9,80,034|
|2b||Stocks – 12%||Rs. 11,23,942|
|2c||Stocks – 15%||Rs. 12,16,700|
As you can see, investment in an FD is the worst option – it gives the lowest return.
Investing is Section 54EC tax saving bonds and getting 12% return from the stock market give more or less the same result.
A return higher than 12% from investing in shares would give the best result.
So, what should you do?
Since investment in stocks gives a return equal to or better than investing in section 54EC tax saving bonds, you should be better off paying 20% LTCG tax and investing the balance amount in stocks.
But you should remember that a 3 year investment in stocks is a medium term investment, is carries some risk – especially when it is a one-time, lump-sum investment.
(What is the alternative to lump-sum investment in stocks? Read “Cost Averaging” for an excellent alternative)
So, if you are risk averse, you should invest the LTCG amount in Sec 54EC tax saving bonds.
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