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3 Ways To Invest And Save Tax With Mutual Funds

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Mutual fund schemes have always been the go-to option when your goal is to generate wealth over a longer horizon. However, in addition to wealth creation, mutual funds are also known for being one of the most tax-friendly investment avenues.

This is primarily because these instruments enable you to enjoy several tax benefits, and taxation only kicks in when you decide to sell the units currently being held. Depending on the fund’s allocation split and type, you get different tax benefits, which help you save on tax.

But, that’s not all. When compared to the traditional tax-saving instruments such as the National Pension Scheme, tax-saver FDs, and Provident Funds, mutual funds come out on top. This is because of a specialised instrument known as the Equity Linked Savings Scheme (ELSS).

With an ELSS, you can benefit from deductions under Section 80C of the Income Tax Act, 1961, and do so without committing your corpus to a long lock-in period.

Read on for more insights on how you can save tax with mutual funds.

Investing in ELSS

As a unique offering, ELSS is a specialised category of mutual funds dedicated to helping you save tax. Here, you get a tax deduction of up to Rs. 1.5 Lakhs, as per Section 80C of the Income Tax Act, 1961 on the principal amount invested. This amounts to a maximum tax saving of up to Rs. 46,800 in a year, depending on your income tax bracket.  For a person in the 30% bracket, the tax on ₹1,50,000 is ₹45,000 plus Education Cess of Rs.1,800 at 4% of ₹45,000. You can claim a total tax deduction of ₹46,800 in a year.

Best of all, the lock-in period is three years with ELSS, and it can help you with your wealth-generation objectives. This is because at least 80% of the assets invested in are equities and similar securities, and these are capable of delivering generous returns.

However, if the goal is to save on tax, you need to invest accordingly. Since the deduction is based on the amount invested, you would need to either invest in a lumpsum or begin investing in SIPs at the start of the year to ensure that you get the tax benefit.

Invest in equity-oriented mutual funds

Equity-oriented mutual funds are those wherein the fund consists of at least 65% equity allocation. These are the typical wealth-generation instruments that are known to carry high risk, but also offer high reward. Even if you choose to go this route as a risk-averse investor, you can enjoy tax benefits.

Here, you get taxed based on the holding period. If you hold equity funds for at least one year, any gains thereafter are considered as long-term capital gains (LTCG) and attract the associated tax. The rate is set at 10%, with an additional 4% CESS.

The tax benefit is that you are only liable to pay the LTCG tax if your financial gains for the given year is over Rs. 1 Lakh. Any gains under that amount are tax free and you enjoy a tax exemption with your mutual fund investments.

Alternatively, if you decide to sell your equity units before holding for one year, you will attract the short-term capital gains (STCG) tax. The rate is set at 15% with an additional 4% CESS.

Investing in debt-oriented mutual funds for at least 3 years

Unlike equity funds, debt-oriented mutual funds or debt funds have different taxation norms. Firstly, you are required to hold units for a minimum of three years for LTCG tax to be applicable. This tax rate is set at 20% and you enjoy the benefit of indexation as well.

Indexation is the major perk here as it enables you to save on the taxes applicable on any LTCG. On the other hand, if you sell units before the three-year mark, you will attract STCG tax. The tax rate here is identical to the tax applicable on your income tax bracket with additional 4% CESS.

Things to keep in mind when investing in mutual funds for tax savings


If you’re looking to maximise your tax savings with mutual funds, here are some considerations to keep in mind:


  1. Lock-in period: ELSS investments keep your funds locked in for three years and you are not allowed to redeem these holdings for this time. With other mutual fund schemes, plan to stay invested and reap the benefits of the LTCG holding period.
  2. Investment horizon: If the goal is to maximise the value from your ELSS investment, you may need to invest for a longer tenor. This helps ensure that you enjoy both the tax benefits and the wealth-generation perks that ELSS can provide.
  3. Fund performance: While this isn’t a sure-fire way to identify the best funds, it does provide some insight. Assess the yearly performance markers and choose funds that have been managed well. Historical performance trends can help you choose funds that will work in your favour.

Mutual funds can help you achieve most financial objective, provided you plan and execute your investment strategy appropriately. These instruments generally require you to take on some risk, and this is something you can handle with good diversification.