What are tax-saving mutual funds?

Investing in mutual funds can offer many advantages, such as diversification, compounded annual growth potential and professional management. However, the taxes you pay on your potential returns can eat into your wealth. Therefore, it is important to find ways to save on tax or reduce your tax burden when investing in mutual funds.

One such avenue, which offers growth potential as well as tax benefits, are Equity Linked Savings Schemes or ELSS mutual funds. This article tells you more about these tax saving mutual funds and how you can use them to your advantage.

• Table of contents

1. Introduction to Equity Linked Savings Schemes (ELSS)
2. How do these tax saving mutual funds work?
3. Features of tax-saving mutual funds
4. Benefits of tax-saving mutual funds
5. Who should invest in tax saving funds?

Introduction to Equity Linked Savings Schemes (ELSS)

ELSS is a type of mutual fund that offers tax benefits to investors. Investments in ELSS schemes are eligible for tax deductions of up to Rs. 1.5 lakh per financial year under Section 80C of the old regime of the Income Tax Act, 1961. This makes them a popular choice for those looking to save on taxes while investing in equities.

How do these tax saving mutual funds work?

ELSS funds invest primarily in equities or stocks. They have a mandatory lock-in period of three years, which means you cannot withdraw from your investment before three years. However, the lock-in period of ELSS funds is one of the shortest among tax-saving instruments in India. For example, Public Provident Funds have a lock-in period of 15 years, and National Savings Certificate has a five-year lock-in.

During the lock-in period, the Net Asset Value (NAV) of the fund may fluctuate based on market conditions. The NAV represents the per-unit price of the fund and is determined by the market value of the securities, among other factors. The value of your investment at the end of the lock-in period will depend on the NAV at that time. You can invest in these funds either as a lumpsum or through a Systematic Investment Plan (SIP), where you invest a fixed amount at regular instalments.

Features of tax-saving mutual funds?

Some key features of tax-saving mutual funds include:

Tax benefits: Investments up to Rs. 1.5 lakh in ELSS are eligible for tax deductions under Section 80C of the Income Tax Act. This can significantly reduce your taxable income and help you save on taxes.

Lock-in period: ELSS funds have a mandatory three-year lock-in period. This is relatively short among tax-saving schemes under 80C. A lock-in period encourages a long-term view to investing.

Potential for high returns: Being equity-oriented, ELSS funds have the potential to offer higher returns compared to traditional tax-saving instruments like fixed deposits or PPF. However, unlike some of the tax saving options, ELSS does not offer assured returns. Over the long term, equities tend to outperform other asset classes, providing an opportunity for wealth creation.

Professional management: ELSS funds are managed by professional fund managers who use their expertise to select a diversified portfolio of stocks. This professional management helps in optimising returns while managing the risks associated with equity investments.

Benefits of tax-saving mutual funds

Investing in tax-saving mutual funds comes with several benefits:

Tax efficiency: As mentioned earlier, these funds offer tax deductions under Section 80C, helping reduce your taxable income. This dual benefit of saving on taxes while potentially earning returns makes ELSS a preferred investment choice for many investors.

Wealth creation: With a significant portion of investments in equities, ELSS funds have the potential to build wealth over the long term. The power of compounding and the growth potential of the stock market can potentially lead to significant wealth accumulation for disciplined investors.

Flexibility: You can start investing a small amount through SIP, making it accessible for investors with varying financial capacities. This flexibility allows you to invest regularly without straining your finances, and also helps in averaging out the purchase cost over time.

Expert management: These funds are managed by experienced fund managers who make investment decisions based on market analysis and research. This professional management aims to optimise returns and manage risks, providing investors with the benefit of expert knowledge and strategic asset allocation.

Diversification: ELSS funds generally allocate their investments across a wide range of stocks from various industries and market sizes. This diversification reduces risk and helps in capturing growth opportunities across the market, contributing to more stable and potentially higher returns over time.

Who should invest in tax saving funds?

Tax saving mutual funds are suitable for various types of investors:

New investors: Those new to the stock market can use ELSS funds as a gateway to equity investments while enjoying tax benefits.

Young professionals: With a long investment horizon, young or early-stage professionals can benefit from the compounding effect and potential high growth of ELSS funds.

Tax payers under old regime: Anyone looking to reduce their taxable income can benefit from investing in these funds, making them a popular choice during tax season.

Conclusion

In conclusion, Equity Linked Savings Schemes (ELSS) are tax saving mutual funds that combine tax benefits with the potential for high returns and can be an attractive option for both new and experienced investors. Understanding how these funds work and their benefits can help you make informed investment decisions.

FAQs

What are tax saving mutual funds?

Tax saving mutual funds, specifically Equity Linked Savings Schemes (ELSS), are mutual funds that offer tax benefits under Section 80C of the Income Tax Act. They invest primarily in equities and have a mandatory lock-in period of three years.

How to invest in ELSS?

To invest in ELSS, choose a fund that matches your financial goals and risk tolerance. Open a mutual fund account through a bank, financial advisor, or online platform. You can invest a lump sum or start a Systematic Investment Plan (SIP) for regular investments.

What are the tax benefits of investing in ELSS?

Investing in ELSS offers tax deductions up to Rs. 1.5 lakh under Section 80C of the Income Tax Act. Additionally, capital gains from ELSS investments are taxed as long-term capital gains owing to the lock-in period. The tax rate for long-term capital gains is lower than that for short-term capital gains.

How to save tax when investing in mutual funds?

If you have opted for the old regime of the Income Tax Act, you can save tax by investing in ELSS to utilise Section 80C benefits. Holding investments for more than three years can also provide tax efficiency due to long-term capital gains tax benefits.

Can ELSS investments provide high returns?

ELSS investments have the potential to provide high returns due to their equity exposure and can outperform traditional tax-saving instruments in favourable market conditions. However, it's important to remember that higher returns come with higher risks and mutual fund returns are not fixed or guaranteed, unlike with traditional savings avenues.

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.