How to get tax benefit or exemption by investing in mutual funds?

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The 5 Cr+ Indians using SIP regularly to invest in mutual funds is clear evidence that the convenience, flexibility, and benefits of mutual funds in India have been widely understood and appreciated. This is true, especially among the younger generation and working population, who do not have the time or the inclination to keep tracking their investments constantly. 

While there are age-old debates of investing in stocks vs mutual funds, we'll see how the benefits of investing in a mutual fund are manifold. Be it diversified asset class, flexibility and convenience of investing, power of compounded returns, liquidity, professional portfolio mix management etc., mutual funds can help in securing a medium-long term corpus. How about the interim, though? Surely, short-term benefits are desirable too. Well, the beauty of mutual funds lies in their variety. Apart from getting exposure to several classes such as equity, debt or commodity, there exists a type of mutual fund that helps you save tax year-on-year. Let us examine these a bit more. 

Tax Saving Mutual Funds - A quick intro

Equity Linked Savings Scheme (ELSS) gives you all the aforementioned benefits of investing in a mutual fund with the added advantage of saving tax each year. Here’s a quick look at their prominent features:

  • SEBI requires ELSS funds to allocate 80% or more of their assets in equity shares and/or other equity-related instruments.
  • This, in turn, makes these funds have a fairly high-risk exposure as they are immediately and significantly impacted by market volatility.
  • On the flip side, greater market upswings and bull runs can also result in higher gains than other investment tools.
  • ELSS funds have a minimum 3-year lock-in period, which means that you cannot withdraw your money until the fixed period has lapsed. But there is no maximum period, you can stay invested as long as you wish to.

What are the tax benefits of investing in mutual funds?

Here’s a quick lowdown on the advantages of investing in ELSS funds.

  • Tax Benefits: Starting with the point of discussion, the Income Tax Act of India under its Sec 80C declares that all contributions made towards ELSS are subject to tax exemption up to ₹1.5 L per financial year. This can be ₹1.5 L in one ELSS fund or split across multiple fund schemes. 
  • Short Lock-in Period: Let us consider some of the other popular tax-saving tools and their respective lock-in periods.
  • Fixed Deposit (FD): 5 years, 
  • Public Provident Fund (PPF): 15 years, 
  • National Pension System (NPS): till the age of 60
  • National Savings Certificate (NSC): 5 years

Clearly, with a 3-year lock-in period, ELSS funds block your money for the shortest time period while giving the same tax benefit of Rs. 1.5 L per year as the other instruments do (albeit over a longer lock-in time frame).

  • Higher Potential Gains: Another aspect worth considering is the potential return on your investment. While market performance can never be truly predicted, ELSS has historically and consistently outperformed the other tax-saving counterparts that usually offer single-digit returns due to its exposure to the equity market.
  • Convenience and Flexibility: Since ELSS is a type of mutual fund, you can invest in it starting as low as Rs. 500 per month via an SIP. This also helps you stay regular with your investment. You can also choose to invest as a lump sum amount. Moreover, it can be entirely managed online without needing to fill out any paper forms or stand in long queues.
  • Diversification: An automatically derived benefit of investing in ELSS is that it aids in diversifying your portfolio. Having a basket of shares and stocks in the portfolio helps decrease your risk and dependency on the performance of a specific company.

Key Factors To Consider Before Investing

Mutual funds come with a whole bunch of benefits beyond saving taxes, but it's understandable why tax-saving funds hold the popularity that they do. ELSS funds are well suited to new investors and anyone who wishes to save tax while generating wealth for the future. However, in the interest of “buyer be aware”, let us also mention the key factors to be taken into account before putting your hard-earned money into these schemes.

  • Risk and Investment Horizon: Most ELSS funds come with a high-risk rating due to their high and direct exposure to the equity market. Moreover, as mentioned earlier, they have a 3-year lock-in period. So, before investing, you need to be clear that your risk appetite allows this and that having your money locked in for three years is financially viable for you. 
  • Historical Performance: You will often hear that historical performance is no guarantee of future returns. However, knowing the past returns trends does help in assessing the performance vis-a-vis the several other funds in the market. Do check their 1-year, 3-years, and 5-years returns to identify the top-performing funds. 
  • Fund Manager’s Experience: Each ELSS fund has a fund manager who is responsible for maximising the returns while keeping risks at a tolerable level. They lead a team of analysts and researchers who keep a tab on market movements and rebalance the portfolio in anticipation of forthcoming changes. Hence, the role of a fund manager is significant as they are managing your investment on your behalf. Moreover, since you cannot withdraw your money before the end of 3 years, it becomes extra relevant to read up on the fund manager and their track record.
  • Expense Ratio: This is how the fund manager and the team involved are paid for their services. This is divided among all investors of that fund scheme and deducted at the time of redemption of units. So, if the ER is 1% and your total fund returns were 20%, you can expect a net return of 19%. The lower the ER, the more returns 
  • Taxation: We’ve discussed most of the benefits of mutual funds in India in terms of taxation. However, you should know how the returns are taxed too. These gains are categorised as short-term or long-term and taxed accordingly. Short Term Capital Gains Tax does not apply to ELSS as it kicks in only when units are redeemed within one year of purchase. Hence, ELSS returns ( above Rs. 1 L per annum) are taxed under Long Term Capital Gains Tax at 10%.

Wrapping It Up

ELSS mutual funds are a unique and beneficial combination of wealth generation while saving annual tax. A taxation limit of Rs. 1.5 L per annum is the reason why many salaried people choose the ELSS way to consolidate their tax savings. Having said that, tax-saving should not be your only goal while investing in ELSS; carefully consider the risk and other factors as well.

FAQs on Tax Saving Mutual Funds

Which mutual funds are covered under 80C?

Equity Linked Savings Scheme (ELSS) is the only type of mutual fund that is covered under the Sec 80C of the Income Tax Act and allows you to save up to Rs. 1.5 L per annum on taxes.

Do you pay taxes on money invested in mutual funds?

If you are paying money in an ELSS fund, then, no, you are not required to pay taxes on the amount up to Rs. 1.5 L. However, for all other mutual funds, there are tax benefits on units purchased and the amount invested.

Can we get tax benefits on a mutual fund?

Yes, you can. To get mutual fund investment tax benefits, you need to invest in an equity-linked savings scheme (ELSS). These schemes are available both in direct and regular plans, which means you can choose to invest them through a broker or agent or directly on your own and pocket the fees and other related charges.

Which mutual fund provides tax benefits?

ELSS mutual funds provide tax benefits in the form of tax deductions of up to Rs. 1.5 L on the amount invested in them in a particular financial year.

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