A Mutual Fund can be defined as a common (mutual) pool of money (fund) managed by a Fund Manager (an individual or a team). Mutual Funds are a great way for individual investors to get easy access to professionally managed and well-diversified portfolios of stocks (equity) and bonds (debt), which may be otherwise outside their reach.
How Do Mutual Funds Work?
To some, mutual fund investments may sound very complicated but we have tried our best to simplify its working so that you have all the information you need to get started, without suffering an "analysis paralysis":
The Fund Manager invests the money collected from various investors into one or multiple types of financial instruments such as equities, bonds, money market instruments etc as per the pre-defined objective of the fund.
Each investor is allotted fund units (similar to shares) in proportion to her investment.
As the value of the assets in the fund portfolio changes, the investors gain or lose based on this delta. The current value of the fund is tracked via its NAV and is usually published at the end of every business day by the Mutual Fund.
Apart from the fund management fees that the Mutual Fund charges you for managing your money on an on-going basis, there are 2 other types of charges/costs that you may incur when you redeem your money.
a. Exit Load
What is Exit Load in a Mutual Fund?
Exit load is like a penalty for withdrawing your investments too soon. Mutual Funds usually do not have lock-ins but they do charge you for very quick withdrawal of funds. Not all funds have it but it is fairly common in equity funds.
Also, the length of time considered as 'too-soon' is generally 1 year for equity funds (there are exceptions) but varies greatly for debt funds.
Why is Exit Load Charged?
The main objective of collecting a certain fee from the investor at the time they choose to exit the investment plan is basically to discourage them from exiting the fund too early and engaging in speculation by frequent buying and selling.
When is Exit Load Applicable?
If you’ve invested in Mutual funds, please make a note of these carefully before choosing to redeem your invested money.
Exit load is only applicable when you sell your Mutual Fund units 'too soon'. Note that this is applicable even if you switch from one fund to another (even of the same Mutual Fund house).
In the case of equity funds, generally 1% of the total amount being withdrawn within 1 year is deducted as exit load. If the units are held for more than 1 year, then no exit load is applicable. This is the most general case. However there are funds with exit load extending beyond 1 year as well.
In the case of debt funds, the exit load is usually nil for Short Term Debt funds; for Medium Term Debt funds it may be nil or have a very short applicable period e.g. a week to a month. For Long Term Debt funds it is usually 1% and the applicable period ranges from 6 months to 1 year.
Important Note: If you’ve invested in Mutual funds via a SIP (Systematic Investment Plan), it is essential to understand that the holding period is applicable for every instalment of the SIP separately. If your first SIP instalment has completed a year, only that instalment can be redeemed without an exit load. All other installments that have been held for less than a year will be levied an exit load on redemption.
How do I check the Exit Load of a Mutual Fund?
Mutual Funds are required to disclose their exit load in the scheme documents. It can be changed over time but all the changes only apply prospectively and not to existing investments.
How is the exit load calculated?
To give you a rough idea about the math behind it, let’s look at a simple example.
Say you have invested Rs. 10,000 in a mutual fund investment plan in January 2018. The exit load at the time of investment was specified to be 1% in case the investor wishes to redeem his money before the expiry of 1 year.
Now, in March of the same year, you choose to invest an additional Rs. 5000 in the same mutual fund. Let’s assume you wish to redeem the entire investment in February 2019. In this case, the initial investment in January last year would have cleared the full one-year term and would, therefore, qualify for exemption from exit load in case of redemption.
However, because the second investment in March ’18 has not yet completed the minimum 1-year criteria, it would be subject to an exit load of 1% on redemption.
Also note that the redemptions follow the First-In First-Out (FIFO) rule i.e. the money you earliest investment will be redeemed first.
So in this case, let’s say the current value of your January 2018 investment is 11,000 and the current value of your February investments is Rs 5500 (total current value = Rs 16500, total invested value = Rs 15,000).
Now in February 2019 if you withdraw only up till Rs 11,000, no exit load will be levied as you are withdrawing from your January 2018 investments.
If in February 2019, you withdraw Rs 15000, then Rs 11,000 is exit load free and there will be a 1% exit load on the remaining Rs 4000 i.e. Rs 40.
Similarly, if you withdraw the entire Rs 16,5000 in February 2019, the exit load applicable will be 1% of Rs 5,500 i.e. Rs 55.
If instead you wait till March 2019 to withdraw, then both your investments will be exit load free and there won’t be any exit loads.
On Goalwise, we keep track of all this automatically and you can see the exit load that will be applicable based on the amount that you are redeeming. We also keep track of how much money can be redeemed without any exit load at any point of time and show that to you, so that you can make the most efficient redemption decisions.
What are the taxes associated with Mutual Funds?
Many of us might wonder, "Are Mutual Funds tax-free?" Now, tax is something you can run from but can't hide from.
Well, may be you can if you own some cool Panama hats but for the rest of us mere mortals, taxes are a certainty wherever there is income, even if it is from Mutual Funds.
But there is good news. Mutual Funds are probably the most tax efficient investment options out there for both equity and debt.
The biggest component of Mutual Fund taxation is the Capital Gains Tax (the tax on profits) which is discussed below. There are some other taxes as well like STT and Dividend tax which are covered in a more detailed post here.
How do I calculate tax liabilities associated with my Mutual Funds investment?
Capital Gains Taxes are applicable only when you sell and only on the gains made on the units being sold.
For Resident Indians, the tax is NOT deducted by the Mutual Fund. Tax is to be paid by you before the financial year ends on your own. For NRIs, the Mutual Funds will deduct the tax (TDS) from the investments when you withdraw the money.
Capital Gains Taxes depend not only on amount of gains but also on the type of investment (equity or debt) and the length of time the investment is held for (short term or long term). See the summary table below.
LTCG in stocks and equity Mutual Funds upto Rs. 1 lakh in a financial year will be free of tax. LTCG Tax at 10% will only apply to equity LTCG beyond Rs. 1 lakh at a PAN level for a financial year.
Indexation means after subtracting inflation from your overall returns i.e. if overall returns are 8% and inflation is 7% then tax applicable is 20% of (8%-7%) = 20% of 1% = 0.2%.
Debt Mutual Funds are 10 times more tax efficient than Fixed Deposits while providing similar safety and returns because of indexation benefits. In FD all gains are taxed at your current income tax level irrespective of how long the FD was kept for. So in this example if you are in the 30% bracket, your tax applicable would be 30% of 8% i.e. 2.4% - more than 10 times than that of debt funds!
[Advanced stuff] In case of losses in one investment, a tax deduction can be claimed for profits in another investment. These deductions can also be carried forward to be offset against future gains, if and when they happen. (This is an oversimplified version of taxation of losses - you can ignore it for now, you will know when you need it).
Again, Goalwise keeps track of all your capital gains automatically and shows you all the relevant capital gains and tax information when you are planning to make a withdrawal.
How do I get the most out of my Mutual Funds investment?
Whenever you consider selling your investments, take these costs into account, or they could eat into your returns.
Awareness of exit loads, charges, and applicable taxes at the time of making the investment itself would come in handy and can save you from making hasty decisions that end up costing you your ‘nest egg’.
More reasons to stay invested for the long-term. :)