The impact of LTCG tax on your portfolio of investments explained

Budget 2018 brought in a 10 percent long-term capital gains (LTCG) tax for long-term gains above Rs 1 lakh. The tax is effective starting April of 2018, or FY 2018-19.

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 annualised 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:

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. The total portfolio is valued at Rs 20 lakh at the end of 10 years.

Scenario 2: The Rs 10 lakh portfolio has 0 returns for 9 years and then gains Rs 10 lakh in the 10th year. The investor now must pay 10 percent tax on Rs 9 lakh in the 10th year. The total portfolio is worth Rs 19.1 lakh at the end of 10 years.

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

The scenario would be the same had the investor not booked profits every year if the gains were evenly spread over 10 years instead of being a 10th year gain only.

This is called path dependency.

If the outcome is path dependent, how does one determine the impact of LTCG tax on the portfolio? For situations like these, analysts 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 an investment horizon of 20 years for three investors.

Investor 1 invests Rs 50,000 a year. Over 20 years, LTCG tax will reduce the portfolio size by 2-10 percent (assuming annualised returns of 5-15 percent).

Investor 2 invests Rs 1 lakh a year. Over 20 years, LTCG tax will reduce portfolio size by 3- 13 percent (assuming annualised returns of 5-15 percent).

Investor 3 invests Rs 5 lakh a year. Over 20 years, LTCG tax will reduce portfolio size by 5-15 percent (assuming annualised returns of 5-15 percent).

As you can see, the impact of LTCG tax is higher for a higher rate of return and for a 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.

Effectively, higher investment or higher returns would lead to higher tax impact. If a 15 percent reduction 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!