TAX BENEFITS OF INVESTING IN MUTUAL FUNDS

Mutual funds offer earnings in two ways – capital gains and dividends. Tax on mutual funds earned via dividends, known as Dividend Distribution Tax (DDT) is paid by the fund house or the AMC (asset under management) on behalf of the investors. On the other hand, capital gains are taxable at the hands of investors.

Tax on mutual funds

Mutual funds are broadly classified into 2 types:

1. Equity mutual funds – Short term capital gains tax (STCG) in equity funds are taxed at the rate of 15% plus 4% cess. Long term capital gains tax (LTCG) in equity funds is taxed at 10% without the benefit of indexation* provided the capital gains in a financial year is over Rs 1 Lakh. Long term capital gains up to Rs 1 Lakh is entirely tax-free.
2. Debt mutual funds – LTCG on debt fund are taxable at the rate of 20% with the benefit of indexation. STCG on debt funds are taxed as the income tax slab of the investor.

To encourage investors to invest in mutual funds, the government of India offers several tax benefits to individuals investing in equity mutual funds. Let’s look at these benefits.

Tax benefits of investing in mutual funds

There are several tax-saving investments available to investors. One of the most common Section 80C investments is ELSS funds, also known as Equity-linked Savings Scheme. These tax saving mutual funds offer a tax benefit of up to Rs1.5 lakh under Section 80C of the Income Tax Act, 1961. Investments in these tax saver mutual fund can help to save up to Rs46,800 each year. These tax-saving investments have a lock-in period of just 3 years, which also happens to be the lowest lock-in period among other Section 80C investments.

As an investor, you can also invest in ELSS funds via SIP (Sysematic Investment Plan) that calls for regular investments and a higher level of financial discipline. However, an investor should note that in this case, each SIP instalment is treated as a new purchase. This is because after 3 years, only your first SIP instalment would have completed 3 years. Additionally, your last instalment would have just completed 1 month (given that the periodicity of your SIP investments is monthly).

Although ELSS funds have a lock-in period of just 3 years, experts often advisestaying invested for a longer duration. Financial advisors recommend investors to link their ELSS investments with a long-term goal so that they are not tempted to exit the scheme and allow their investments to deliver significantly higher returns.

Investors investing in mutual funds should always consider tax planning as taxes can eat a huge chunk of your earnings. At the same time, one should not invest in mutual funds with the sole purpose of tax saving. Your goals, risk profile and investment horizon should align with your mutual fund investments. Happy investing!

*Indexation is a technique of factoring inflation from the time of purchase to sale of units.It permits inflating the purchase price of debt mutual funds to bring down the value of capital gains.