Investing in mutual funds is more than useful for generating wealth alone. There are numerous ways in which mutual fund investments can help you gain tax benefits. Here’s a quick look at what you need to know:
Equity Linked Savings Scheme is a diversified mutual fund where a chunk of the investment money is invested in equity and equity-related assets. It is also the only mutual fund that is eligible for deduction under Section 80C of the Income Tax Act. The maximum investment amount that is eligible for deduction under this section is INR 1.5 lakhs. So even if you are in the highest tax bracket, you can save above INR 40,000 in taxes.
There is no short-term capital gains tax for ELSS as that kicks in only when redemption is done within a year of purchasing the units. On account of the lock-in period, returns from ELSS above INR 1 lakh in a financial year are only taxed as long-term capital gains at 10%.
However, bear in mind that the cap under Section 80C is inclusive of the deductions made by the employer for employee provident fund, PPF, life insurance premiums, and NSC.
Despite the attractive tax benefits offered, remember that ELSS funds have a high-risk rating on account of their direct exposure to the equity market. They also have a three-year lock-in period. So you should be absolutely certain whether you have the risk appetite for investing in ELSS and whether such an investment aligns with your goals and investment horizon. Do not fall prey to ELSS investments only for tax benefits.
Debt mutual funds
Another way to save taxes is through investing in debt funds. These funds have a minimum holding period of 3 years. If the units are sold before three years, you get short-term capital gains which are taxed as per the applicable tax rate for you. There is no way you can escape paying taxes on short-term gains.
In the case of long-term capital gains where you sell the units after the expiry of the holding period, the tax is at 20% with indexation. The Indexation benefit brings down your tax obligation to a great extent when compared to the taxation on investments in fixed deposits in banks and small savings schemes. So the smartest strategy to gain tax benefit is to remain invested in your debt fund for 3 years or longer so that you can enjoy the indexation benefits.
Moreover, you also enjoy tax-free dividends as the tax is paid by the mutual fund house prior to dividend distribution.
Equity mutual funds
One year is the minimum holding period of equity mutual funds. The long-term capital gains tax rate for such funds is 10% when the gains are above INR 1 lakh in a financial year. If your told gain is INR 1.1 lakh in a financial year, then you only need to pay a tax of 10% 10,000 whereas the remaining Rs. 1 lakh is tax-free. Therefore, it is smarter to limit your long-term capital gains from such equity mutual funds to INR 1 lakh in a financial year so that you don’t have to pay any taxes on the returns.
However, if you sell the units before the holding period, you get short-term capital gains which are taxed at the rate of 15% plus a 4% cess. Similar to debt funds, there is no way at present to reduce your short-term capital gains tax.
The dividends from your equity mutual funds are tax-free at your hand as the mutual fund house already pays the dividend distribution tax prior to announcing the dividends.
Tax saving is an important benefit of investing in mutual funds. However, it is advisable to not choose a mutual fund simply because it offers superior tax gains. Any investment you make should suit your financial goals and risk appetite. Make sure to carefully weigh in the pros and cons before you decide. Think of tax gains as an added benefit of mutual fund investment instead of the sole feature offered. That will ensure you make the right choice.