Balanced advantage funds: A comprehensive taxation guide

Posted On: 28 November 2023

Balanced advantage funds categorised under hybrid funds have become quite popular amongst investors over the years. Also known as dynamic asset allocation funds, these schemes invest dynamically across equity and debt. Based on market conditions, they change the allocation between the two asset classes to optimize the return potential.

This dynamic asset allocation is done by the fund manager on your behalf. Thus, as an investor, you get the benefit of professional management of both equity and debt investments in a single fund. But how does a balanced advantage fund’s tax efficiency work and what are the tax implications for investors?

Let's understand these aspects in detail.

Table of contents

What are balanced advantage funds?
Understanding Tax Efficiency in Balanced Advantage Funds
Tax treatment of balanced advantage funds
Taxation of equity-oriented balanced advantage funds
Taxation of Non-Equity Oriented Balanced Advantage Funds
Taxation of investments in balanced advantage funds
Strategies for Optimising Tax Efficiency in Balanced Advantage Funds
What are the risks of balance advantage funds?

What are balanced advantage funds?

Balanced Advantage Funds (BAFs) are hybrid mutual funds that adjust the allocation between equity and debt based on market conditions.

Key features:

Dynamic asset allocation: BAFs don’t maintain a fixed equity-debt ratio. Fund managers actively adjust the allocation using quantitative models.

Risk management: The dynamic strategy reduces risk by shifting to safer debt instruments during market downturns and increasing equity exposure in favorable conditions.

Potential for higher returns: By adjusting the portfolio actively, BAFs aim to offer higher returns compared to traditional balanced funds.

Lower volatility: Compared to pure equity funds, BAFs tend to have lower volatility due to their inclusion of debt instruments.

Understanding Tax Efficiency in Balanced Advantage Funds

Before delving into strategies, let us understand how BAFs are taxed based on their equity orientation. If the equity allocation in a BAF is 65% or more, it is categorised as an equity-oriented fund. In such cases:

● Long-term capital gains (holding period over 1 year): Long-term capital gains tax-exempt up to Rs. 1.25 lakh. Anything above this limit is taxed at 12.5%.

● Short-term capital gains (holding period less than 1 year): Attract a 20% tax.

This enables investors to enjoy the lower long-term capital gains tax rate, making BAFs tax efficient. However, if the equity allocation drops below 65%, the fund loses its equity status.
Then, capital gains irrespective of the holding period are taxed as per the applicable income tax slab rates.

Tax Treatment of Balanced Advantage Funds

To understand the taxation of balanced advantage funds, we first need to know how mutual funds are classified from a tax perspective.

Equity-oriented funds: These are funds that invest a minimum of 65% of their assets in equities or equity-related instruments.
Non-equity oriented funds: These funds invest 35% or less of their assets in equities. They are primarily debt funds that invest in fixed income securities.

The tax treatment of balanced advantage funds depends on their equity allocation.

Equity-oriented balanced advantage funds are eligible for taxation benefits like lower long-term capital gains tax.

Gains earned from non-equity-oriented balanced advantage funds are added to your total taxable income for the year and taxed as per the income tax slab you qualify for, irrespective of the holding period.

Taxation of Equity-Oriented Balanced Advantage Funds

When the equity allocation in a balanced advantage fund is 65% or above, here is how it is taxed:

Long-term capital gains: Gains made if units are redeemed after 1 year are tax-free up to Rs. 1 lakh. Any long-term gains above this limit are taxed at 10%.
Short-term capital gains: Gains made if units are redeemed before 1 year attract 15% short-term capital gains tax.

So, equity-oriented balanced advantage funds allow you to enjoy the lower 10% tax rate on long-term gains, which makes them tax-efficient.

Taxation of Non-Equity Oriented Balanced Advantage Funds

If the equity exposure in a balanced advantage fund falls below 35%, it loses its equity-oriented status. Here's how it gets taxed:

Capital gains: Irrespective of the holding period, all capital gains are taxed as per the income tax slab rates applicable to you. No distinction is made between short-term and long-term.

So, it is essential that the fund manager maintains the minimum 65% equity allocation if you want to enjoy the balanced advantage fund tax benefits.

Taxation of Investments in Balanced Advantage Funds

When you invest in a balanced advantage fund, units are allotted to you based on your investment amount and the Net Asset Value (NAV) on that day.

Later, when you redeem your units, the gain or loss is calculated as:

(Sale price - Cost price) x No. of units

Sale price: NAV on the day you redeem units

Cost price: NAV on the day you invested in units

This gain/loss qualifies as capital gains and is taxed accordingly.

Now let's understand how the holding period is calculated which determines if the gains qualify as long-term or short-term.

Equity funds: The holding period rule is 1 year. So, if you remain invested for over 1 year before redemption – the gains are long-term. Less than 1 year – the gains are short-term.
Non-equity funds: There is no distinction between short-term and long-term debt funds. Irrespective of how long you remain invested, gains are taxed at your income tax slab rate.

The calculation of the holding period starts from the day units are allotted to you.

For example, if you invested in an equity-oriented balanced advantage fund on 1 January 2022 and redeemed units on 15 March 2023, your holding period is 1 year and 2 months. This qualifies the gains as long-term. You can also use a Compounding Calculator to get a tentative idea of the potential gains on your investment, based on the investment amount, expected returns and tenure.

Strategies for Optimising Tax Efficiency in Balanced Advantage Funds

With this backdrop, here are some strategies that can optimise tax efficiency when investing in BAFs:

● Focus on equity-oriented BAFs: As discussed earlier, funds with over 65% equity allocation get preferred tax treatment. Hence, investors may prioritise equity-oriented BAFs to maximise tax savings opportunities. They should monitor equity exposures regularly and redeem from funds that fall below the 65% threshold.

● Invest for the long term: Since long-term capital gains are either tax-exempt or taxed at a lower rate of 12.5%, investors must hold their BAF investments for over a year to avail of this benefit. Opting for STP or systematic transfer plans can help maintain long holding periods. Investors can also use an SIP goal calculator to determine the appropriate monthly investment amounts, helping them adhere to their long-term investment strategies.

● Stay updated on tax regime changes: The Indian tax landscape keeps evolving. Investors must keep track of the Union Budget announcements and regulatory changes impacting equity/debt taxation or capital gains. Advanced planning allows one to maximize the potential benefits and reduce the tax outgo.

● Tax loss harvesting: Selling off loss-making units allows setting off gains, thus lowering the overall tax liability. However, investors must purchase back similar assets within 3 months to avoid wash sale adjustments. This strategy is suitable for experienced investors with adequate surplus funds.

● Evaluate periodic returns post-taxes: When selecting funds, evaluating not just pre-tax but post-tax returns over various periods (1, 3, 5, 10 years, etc.) is essential. This gives a true picture of how different funds have actually fared from a taxation perspective as well. A lumpsum mutual fund calculator can be a useful tool to estimate the potential returns of balanced advantage funds (BAFs) and compare them to other investment options. The calculator accounts for your investment amount, tenure and expected returns to project your potential final corpus. Do note, however, that the calculator's estimates are just an indication and there is no assurance that returns will be along expected lines.

What are the risks of balance advantage funds?

Balanced advantage funds, while aiming to provide balanced growth potential, carry certain risks. These include:

● Market risk: These funds still invest significantly in equities, exposing them to stock market volatility.

● Interest rate risk: The debt portion of the portfolio may be impacted by rising interest rates, potentially decreasing bond values.

● Complexity: The dynamic asset allocation strategy may be difficult to understand, especially for new investors.

● Management risk: Fund performance heavily depends on the fund manager’s ability to adjust allocations effectively; poor timing or sub-optimal allocation can impact returns.

Conclusion

Balanced advantage funds can help make your investing more tax-efficient compared to managing your equity and debt investments separately. Using an SIP mutual fund calculator or a mutual fund lumpsum calculator can help you estimate potential returns from your investments, which can assist you in planning better. However, maintaining the minimum 65% equity allocation is crucial to enjoy the taxation benefits. Review the fund's asset allocation and performance regularly. Use the capital gains statement to accurately file your tax returns. With some prudence, balanced advantage funds can add tax optimization to your portfolio.

FAQs:

How are taxes calculated in balanced advantage funds?

Balanced advantage funds are taxed based on their equity orientation. If the equity allocation is 65% or more, then the fund is considered equity-oriented and taxed as follows:

● Long-term capital gains: Gains exceeding Rs. 1.25 lakh on units held for more than a year are taxed at 12.5%. Gains up to Rs. 1.25 lakh are tax-exempt.

● Short-term capital gains: On redemption before one year, capital gains are taxed at 20%.

However, if equity allocation falls below 65%, then irrespective of the holding period, all capital gains are taxed as per the slab rates applicable to the investor.

What is the ideal holding period for tax efficiency?

The ideal holding period for maximising tax efficiency from equity-oriented balanced advantage funds is over 1 year. Gains earned from equity-oriented balanced advantage funds (with over 65% equity allocation) that are held for more than one year qualify as long-term capital gains. Those who are investing in a balanced advantage fund in lumpsum can consider using a daily compound interest calculator to estimate the potential returns on their investment. This can also help them calculate the possible capital gains on their investment and optimise their withdrawal strategy for tax-efficiency. Do note, however, that the calculator's projections are indicative and there is no gaurantee that returns will be achieved or

How is the balanced advantage fund taxed?

The taxation of balanced advantage funds depends on equity allocation. Equity-oriented funds (65%+ in equities) follow equity fund taxation: LTCG over Rs 1.25 lakh taxed at 12.5% in a financial year; STCG taxed at 20%. Non-equity-oriented funds are taxed like debt funds, with LTCG and STCG added to total income.

What are the disadvantages of a balanced fund?

Balanced funds offer growth and stability but come with potential disadvantages. They may deliver moderate returns due to debt exposure, provide limited control over asset allocation, and remain vulnerable to market and interest rate risks. Additionally, management fees can affect overall returns.

What is the best tax-free investment?

The most suitable tax-free investment depends on your financial goals and risk tolerance. Popular options include PPF for stability, ELSS for higher potential returns with a shorter lock-in, and NPS for retirement planning. Each varies in risk and horizon.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.