The Art of Investment Churning : Save Taxes without any Investments

I have seen so many people struggle to meet their investment target to save taxes every year. Usually, the insanity is at its peak during the last month of the financial year. The chaos is so much that people often tend to buy useless insurance products and get stuck with a life time commitment, just to save taxes for one year. 

On the brighter side, there are techniques that can help you in such cases, Investment churning being one of them.

What is Churning?

Imagine a cylindrical pipe - open at both ends - which has a capacity to hold up to 5 balls one behind the other. You can push in only 1 ball in that pipe in one year. If you do not put in a ball in any particular year, the rule says that you will be penalised. 

You being a disciplined person, you go ahead with your commitment and start putting in one ball per year.

In Year 1, the pipe will have 1 ball, 2 balls at the end of second year, and so on..till you reach Year 5 when the pipe will become full to its capacity. 

Now, what do you do in Year 6 ? Either you pay the penalty or you do what I would call as Ball Churning.

To avoid paying penalty for not inserting a ball in the pipe, you push the 6th ball in the pipe from one end. What will happen? Since the pipe is open at both the ends, the first ball that you inserted in Year 1 will come out of the pipe from the other end. That ball is for you to keep. 

So, in nutshell, you added one ball to the pipe and got one ball back from the pipe. In effect, you did not add anything, but you saved the penalty because the penalty was on not adding the ball in a particular year, and you of course did add the ball, isn't it? This process of churning the balls to avoid penalty is known as ball churning.

Investment Churning

How does the idea of Investment Churning sound to you? This means that you have a technique via which you have some investments which you could churn i.e. not invest anything but still gain from it. How does it feel? It is exciting, of course.

Let me show you how you can manage this - both with an example of a debt based and an equity based investment.

Investment Churning in Tax Saving Debt Investments

Now, let us apply the concept of ball churning in our investments and tax savings. 

Let us say you have a PPF Account (which is similar to the pipe as in above example). 

You can invest at most 1.5 Lacs per annum in your PPF Account in any given year. 

Every time you invest 1.5 lacs, you avoid getting penalised with income tax on the invested amount in that financial year. 

So, in Year 1, you invest 1.5 Lacs. Next year, you invest another 1.5 Lacs to avoid the tax penalty of year 2. You keep investing 1.5 lacs every year, to avoid getting penalised with Income Tax. 

Now, what happens after 5 years. 

After 5 years, you can start doing, what I call as, Investment Churning. 

You invest another 1.5 Lacs from one end, but now you can also withdraw from your earlier invested money in PPF account. 

So, in nutshell, in Year 6, you would be theoretically investing zero amount or less than the mandated 1.5 Lacs, but would go on to take the full benefit in terms of tax savings on the entire 1.5 Lacs. 

You will not be penalised even though you did not invest a net amount of at-least 1.5 Lacs. This is what Investment Churning is, and is a very effective technique if you are short of liquid cash for investments in a particular financial year.

So, Investment Churning is an effective strategy in debt based tax saving instruments to save money without doing net investments worth in proportion to the tax saved.

Investment Churning in Equity Investments

The above example of investment churning in PPF, which is a debt based investment, has only one major benefit. And the benefit is that you can take care of your liquidity crunch by churning money, while still saving full taxes. 

Same technique can be applied to Equity based tax saving instruments as well. 

For example, you can apply the same concept to an ELSS (Equity Linked Saving Scheme) based Mutual Fund, and save taxes on investing in ELSS Funds, even without effectively investing anything after a few years.

But when it comes to equity, there is another distinct advantage of this churning of your investments. Not only you can save taxes by churning your investment under Section 80 C at the time of investing, you can also save yourself Long Term Capital Gains tax (LTCG) if you are smart enough.

Let us say that you invest 1.5 Lacs of money in an ELSS Fund every year, and you save taxes as per Section 80 C. And after the lock in period of 3 years (i.e. from the 4th year), you can start to churn your investments and continue to save full taxes without effectively investing any net money in your ELSS funds. 

But this is not all. 

All equity funds have to pay a Long Term Capital Gains Tax (10% as on date) whenever they are realised. 

If you start to churn your money after 3 years lock in of ELSS Funds, you also take advantage of the waiver on Long Term Capital Gains Tax - up to a max of 1 Lac per year. How? This is how you do it. 

Since you would be selling units after the 3rd year as a part of the churning activity, you will incur long term capital gains and since the churn happens, your units are sold off, and the capital gains is realised, the capital gains are actually never accumulated. 

For most investors, the gains may remain below 1 Lac per financial year if they are regularly churning the investments. And that is how they will be able to even completely avoid paying any long term capital gains tax.

A Combined Example

Consider a case where you invest 1.5 Lacs every year in an ELSS Fund to save taxes and get good returns on your long term investments.

The following table lists the annual investments made each year (1.5 Lacs every year) which allows for tax saving on investments. The next col in the table mentions the cumulative balance of your investment at the start of the year. And the last col denotes the approx value of your investment at the end of each year (assuming that we earn 10% returns every year on the cumulative balance at the start of the year).

Now, at the end of year 3 (beginning of Year 4), you have approx 7.06 Lacs, your lock-in for the investments done in Year 1 is over, and you can now take out what you invested at the beginning of year 1. 

Now, if you are smart, you would churn your investments and take out, say 1.5 Lacs from your ELSS fund, and reinvest in Year 4 beginning. Following would be the impact of this investment churning:

1/ You have churned the money and without making any net investment in Year 4, you will save full tax as per Section 80 C.

2/ Also, since your Long term capital gains would be only around 0.5 lacs (@ 10% per annum for 3 years on 1.5 Lacs invested in Year 1), and this amount is much lower than the limit of 1 Lacs per financial year, the entire capital gain would be tax free.

Summary

Investment Churning is a very effective tool. I have not seen many people using it. 

In debt, it is very simple to use as well. 

In equity, your capital gains calculations may become a little complex but it is worth the amount to be paid to your CA. 

The best point of Investment Churning in Equity is that it is insulated from market volatility, since you are exiting as well as entering the equity market at the same valuation. When used smartly, it can help you in times of liquidity crunch and helps you save taxes at the time of investing (Sec 80 C) and also at the time of churning (Long term Capital Gains Tax)

Regards

Manoj Arora

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