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Tax Saving Mutual Funds

Nothing is more certain than death and taxes. The truth of this becomes apparent when March approaches and you have to think about paying your taxes. Shelling out large amounts as income tax is quite painful for most people, but the income tax department does offer relief under various sections of the Income Tax Act so that paying taxes isn’t so burdensome. One of these sections is 80C, under which you can knock off Rs 1.5 lakh from your taxable income and thus save a considerable amount of income tax. There are various options available to you under this section. Among them are tax saving mutual funds. These tax saving funds come under the category of equity-linked savings schemes, or ELSS as they’re popularly known.

What are tax saving investments?

Tax saving mutual funds are not the only investment avenue to save tax. They may be the best option depending on your risk appetite and investment goals, but you have other options as well. You must not ignore these investments because they can lead to substantial income tax savings. For example, if you are in the highest tax slab and paying an income tax of 30 percent, you could end up saving over Rs 46,000. If you are in the 20 percent slab, you save around Rs 31,000 and around Rs 7,700 if you are in the 5 percent slab. Let’s take a look at your options under Section 80C:

  • Tax saving funds or ELSS funds: Almost all fund houses offer tax saving mutual funds. These are basically equity funds that invest in shares of companies. Many investors find these funds attractive because of the high returns they offer. One study found that such funds made three times the returns earned on the Public Provident Fund (PPF) over a 20-year period. Of course, the thing to remember about these funds is that like all mutual funds that invest in equity, they are prone to market risk. ELSS funds do not offer assured returns because they are prone to the vagaries of the stock market, and returns may vary considerably according to market conditions. Such funds also have a lock-in period of three years.

  • Public Provident Funds (PPF): PPF is suitable for investors who want assured returns and minimal risk. Since this scheme is backed by the Government of India, the risks involved are low or non-existent. And considering the low risks, the interest rates are not bad either. These rates are fixed by the government every quarter, and as of January 2019, it was 8 percent. From the tax point of view, there are two benefits. One is that the principal invested is allowed a deduction from taxable income. Two, the interest earned is also exempt from tax. The only disadvantage is that it’s not very liquid since you have to remain invested in the scheme for a period of 15 years. However, partial withdrawal is allowed after a few years. Employees Provident Fund (EPF) offers similar benefits for salaried employees.

  • National Savings Certificate (NSC): Another government-backed scheme is NSC, which can be purchased at post offices. These instruments have a lock-in period of five years and interest rates are fixed by the government. Interest earnings, however, are added to your income and taxed according to the slab you are in.

  • Tax-saving fixed deposit: Banks and post offices offer five-year deposits which you can use to reduce Rs 1.5 lakh from your taxable income. However, interest earned on them is fully taxable.

Why tax saving mutual funds

  • Higher returns: ELSS funds offer much higher returns than most other investment options available to you under Section 80C. You not only get to save tax but also enjoy the benefits of investing in equity. Equity has over the years outperformed most other asset classes, including gold and real estate. And in a growing economy like India, as companies grow and prosper, the prospects of earning good returns are much higher. However, you must remember that these funds are subject to market risk, and you must weigh your options carefully before investing. Plus, you must also consider the lock-in period of three years, so you may not be able to withdraw funds when market conditions are not good.

  • Professional management: Like all other mutual funds, tax-saving funds are managed by fund managers with requisite qualifications and experience. They are able to maximize returns and minimize risks by buying and selling stocks at the right time and the right price. For the lay investor, the services of a fund manager are invaluable because it takes a lot of time and research to find the right stocks to invest in. These funds charge a small amount to manage your funds, and that is called an expense ratio. But it’s a small price to pay to maximise returns.

  • Liquidity: ELSS funds are subject to a lock-in period of three years, so you won’t be able to redeem your investments from the scheme during that period. However, if you compare these funds to other investment options in the same category, you will find that they are quite liquid. For instance, PPF has a lock-in period of 15 years, fixed deposits for five years and NSC five years. Besides, by staying invested in equity for three years, you will be able to earn much higher returns.

  • Systematic Investment Plan (SIP): Another advantage of a tax saving mutual fund is that you will be able to invest small amounts each month according to the investible funds at your disposal. You can start a SIP for as little as Rs 500 a month. Of course, if you want to take full advantage of the income tax deduction you will have to invest Rs 1.5 lakh, or Rs 12,500 a month. Apart from the convenience of investing small amounts, SIP has another advantage, and that is you enjoy the benefits of rupee cost averaging. By investing at a steady rate irrespective of market conditions, you average out the cost of acquiring mutual funds units. So you don’t have to worry about getting the timing wrong and invest a lump sum when prices are falling.

  • Diversification: The best portfolio is one that is adequately diversified, with a mix of investments of varying risk profiles and time periods. So when one investment is not doing well, others will make up for the shortfall. For example, equity and interest rates generally move in different directions. When interest rates are high, equity markets don’t do well. So by having some fixed income instruments in your kitty, you can negate the effect of a bear market to some extent. Tax savings funds should be part of that mix, giving you exposure to the equity market and the resultant higher returns, and of course, the benefits of the lower tax.

  • More choice: You get more choice while investing in a tax saving fund, depending on your investment goals and risk appetite. Not all ELSS funds are the same. Some, for example, may invest more in large-cap companies, which offer more stable returns but on the lower side. Others may place their bets on the mid-cap or small-cap companies, which will offer better returns but also involve more risk as these are relatively unknown entities and their prospects are unclear. You can look at the composition of the fund’s portfolio and find out which one suits you the best.

  • Low-cost investments: A mutual fund is a great way of investing in the stock market, especially for lay investors. One of the advantages is lower transaction costs. Fund houses buy and sell large quantities of shares. This enables them to get better deals in terms of brokerage. Lower brokerage costs mean less costs per unit. These lower costs are ultimately passed down to the buyers of mutual fund units. If you had to buy individual shares that make up a basket of stocks in a mutual fund on your own, you would have to pay much higher transaction costs.

  • Easy to track: It’s easy to track the returns you are earning from your mutual funds. Information about them is publicly available and you can track mutual fund performance on an everyday basis. You can check how your fund has been faring over various time periods, like a month, year, or even ten years. You can compare performance with other funds and check whether your investments are performing in the way you expect them to do. If they aren’t, there are other funds in the sea.

Get better returns with tax saving mutual funds

Even if you ignore the tax aspect, they should be an integral part of your investment plan just because of the returns they make. Studies have shown that equity has performed far better over the past couple of decades than any other asset class, whether it’s gold, fixed income instruments like bank deposits, or even real estate in some instances. Of course, equity investments are subject to market risk, but over the longer term, especially in a growing economy like India, your best bet to create wealth is to invest in equity funds, especially the ELSS variety.

Tax savings fund investment guide

  • Check the returns: Not all ELSS funds are the same and do not offer the same kind of returns. Unlike a tax saving fixed income instruments like PPF or NSC, there’s no such thing as a guaranteed return on your investment in the case of a tax saving fund. So before you take the plunge, you must do a careful comparison of returns on various funds over various time periods. Three years is good enough time to find out how well a fund is doing, so make sure you do that comparison. The Angel BEE mutual fund investment app offers ratings of mutual funds, so you can download it to make the optimum choice.

  • What’s the portfolio like?: Another thing you should remember to check is the composition of the portfolio. Is it filled with large-cap stocks? If it is, it’s suited for investors who are content with relatively low returns in exchange for lesser risk. Does it have a more small-cap and mid-cap stock? If that’s the case, you could possibly earn more returns, but the risks will be commensurately higher. So choose a fund that best matches your risk appetite and investment goals.

  • Expense ratio: Mutual funds charge a certain amount to manage your portfolio. This is known as the expense ratio, which is used to cover administrative and other costs. It is a percentage of the fund’s assets under management (AUM). You have to consider this while making your investment calculation since a higher expense ratio will eat into your returns. For example, if a fund makes a return of 10 percent per annum, and the expense ratio is 2 percent, your effective return will be just 8 percent. Of course, that shouldn’t be the only consideration. Some better performing funds to charge higher expense ratios – if you want to make money you’ve got to spend it too!

  • Liquidity: You must also consider how important liquidity is to you. Invest in ELSS funds only if you can spare money for three years since they have a lock-in period for that time.

  • Fund house: It’s better to invest in a mutual fund scheme from a reputed fund house which has been around for a few years. Information on them and their schemes are readily available for a longer period of time. The new kids on the block may have very good schemes, but you will have no way of finding out whether they’re capable of delivering on their promises.

  • Fund managers: Information on fund managers is fairly accessible to investors. Check his record on managing mutual fund schemes, whether they have delivered high returns. You can also find out if his or her investment philosophy matches your own – whether he’s a risk taker or someone who proceeds with caution.

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