HOW TO SAVE TAX BY INVESTING IN MUTUAL FUNDS
What if someone told you that you could create long-term wealth while enjoying tax
benefits? Traditional saving instruments with a big lock-in period may come to mind. But
there are other tax-saving instruments with a shorter investment horizon that may also
give you relatively reasonable returns.
An equity-linked savings scheme (ELSS) is a type of mutual fund product that doubles up
as a tax-saving instrument.
What is ELSS (Equity Linked Savings Scheme)?
Simply put, ELSS is an equity oriented mutual fund eligible for tax deductions under the
Income Tax Act, 1961. ELSS mutual funds are open-ended equity oriented schemes that
invest primarily in domestic company shares and generate growth via capital appreciation
for investors. The returns from ELSS funds are linked to stock market performance. To
benefit from the tax subsidies, you have to invest in ELSS funds for a minimum of three
years.
ELSS funds can be categorized into:
Growth option: ELSS growth option can help with wealth creation. The investor
receives the full redemption amount as a lump sum at maturity.
Dividend option: ELSS dividend option give investors dividend income through the
course of the scheme. As an investor, you can choose to receive payouts whenever the
fund declares dividends, or you could choose to reinvest them.
Tax benefits of investing in ELSS
ELSS mutual funds allow you to save tax under Section 80C of the Income Tax Act, 1961.
Investments of up to ₹1,50,000 are eligible for annual tax deductions. Although you can
invest more, any excess amount will not qualify for deductions.
The returns generated from ELSS funds incur long-term capital gains tax at 10 per cent if
total long term capital gains amount from equity oriented mutual funds/ equity
shares are higher than ₹1,00,000 in a year. If you opt for a dividend option,
dividends shall be taxable in the hands of the investors and the mutual fund will deduct
TDS @10% for resident investor and @20%(plus applicable surcharge and cess) for
non-resident investor before payouts. However, the Investor can claim tax credit of TDS
deducted at the time of filing of their annual returns.
Despite this, ELSS funds can be considered one of the best tax-saving investment option
because of their high return probability, as well as the relatively lower lock-in
period, compared to other alternatives.
How to invest in ELSS?
Just like other mutual fund schemes, you can invest either a lump sum amount or choose a
Systematic Investment Plan (SIPs). In case you opt for the later, note that each SIP is
considered a separate investment and hence, has an individual lock-in period of three
years each. Investors can use a SIP calculator to calculate and estimate the returns on
your SIP investment. Generally, the minimum lump sum investment amount in an ELSS fund
is ₹500.
Investing in ELSS is just like investing in other mutual funds. You can opt to contact a
mutual fund distributor or choose to invest online.
How to choose an ELSS fund?
Once you have decided between a growth or dividend option, depending on your goals,
evaluate different schemes based on their historical performance. Though this is not a
guarantee for future performance, it can be a fair indicator. Also, check for
consistency of returns. Other criteria to consider would be age and fund size. A larger
fund sustaining over a period of time indicates higher trust among investors.
However, you should also check other indicators and pick a fund most in line with your
financial objectives rather than going with the market trend.
Things to consider while investing in ELSS (Tax Saving Mutual Funds)
When you invest in ELSS tax-saving mutual funds, there are certain things you must keep
in mind before making the decision:
- Goals: Outline the reason to invest in ELSS funds. In addition to saving tax,
the returns can also help you meet other goals like going on vacation or purchasing
a vehicle.
- Risk: ELSS funds invest mostly in equities, meaning they are risky
instruments. Returns are not guaranteed. Therefore, ensure you have the risk
capacity to invest in them.
- Tax exemption: ELSS investments are eligible for up to ₹1,50,000 tax
deductions a year under Section 80C of Income Tax Act. However, the section also
includes other options like provident fund and life insurance policy. If you have
other claims, the entire ELSS amount may not be eligible for deductions.
- Time horizon: ELSS funds cannot be redeemed for at least three years. Make
sure you do not need the funds during that period.
What to consider before investing in ELSS?
- ELSS are equity oriented mutual funds that double up as tax savers.
- When you invest in ELSS, up to ₹1,50,000 per annum can be claimed as tax deductions
under Section 80C of the Income Tax Act.
- Returns (from equity oriented mutual funds and equity shares) over ₹1,00,000
will attract long-term capital gains tax at 10 per cent .
- The lock-in period is three years, but you can extend your investment for longer.
- Although the potential for returns is high, ELSS is still a risky investment.
Takeaway
Equity-linked savings schemes can be one of the better options that could help to build
wealth while also saving you taxes. However, just like any other investment, do your
research, evaluate your financial goals, and ensure you know the features before you go
all in.