A Complete Guide to Tax Saver Mutual Funds: How Does It Work?

The primary goal of an investor is to seek opportunities to receive regular returns in order to create long-term wealth and save taxes at the same time. If you think that you can achieve your financial objectives with savings alone, you are living in the dark. Piling cash in the savings account is never a good option as the interest rates are lower than the prevailing inflation rates. Experienced investors choose tax saver mutual funds for investing a portion of their capital as they provide high returns at a fraction of the risk included in other investment instruments.

What are Tax Saver Mutual Funds?

Tax saver mutual funds are defined as tax saving mutual funds for tax benefit and are just like any other mutual fund investment. However, the main motive behind investing in tax saving mutual funds is their tax-saving benefit under section 80c. Section 80C of the Income Tax Act 1961 provides numerous tax-saving investments to the investors to get a tax deduction of up to Rs 1.5 lakh. 

There are various investment instruments under section 80C, one of which and the most widely invested is tax saver mutual funds. For example, if your total taxable income is Rs 10,00,000, you can lower it to Rs 8,50,000 by investing in mutual funds under 80C. 

Best tax saving mutual funds under section 80C is in the form of the Equity Linked Saving Scheme. These ELSS funds are open-ended equity funds and primarily invest in equities and other equity-related investment products. When an investor invests in tax saver mutual funds, the invested amount up to Rs 1,50,000 is subtracted from the total taxable income as a tax deduction, effectively lowering the taxable income and the payable tax amount

How does Tax Saver ELSS Fund Work?

Tax saving mutual funds or the equity-linked saving scheme collects the investors’ money and adds it to the total pool. The corpus is then invested in the equity market by fund managers in such a way that the profits of other investments balance out the losses, if any. 

For example, if a stock of a company included in the portfolio makes losses while all other stocks realise profits, the profits balance out the loss, and the portfolio remains profitable. The balance is achieved by diversifying the investment across numerous sectors. A typical tax saving mutual fund may break up the investment in the following manner: 

The above table shows how the invested money of an investor is allocated through tax saver mutual funds. If an investor has invested Rs 10,000, it would mean that 15.50%, i.e., Rs 1,550, will be invested in stocks of the banking sector.

Tax saving mutual fund for tax benefit in the form of ELSS comes with a lock-in period of three years. If the investment is made using the SIP method, the lock-in period for each instalment is also three years. The redemption of mutual funds under 80C is limited to the unlocked units of the tax saver mutual funds. 

Hence, investors can only redeem the unlocked units at the current NAV. The NAV, or net asset value, is the value of each unit at a particular point in time, based on the underlying asset’s price.

Features of Tax-Saving Mutual Funds

Equity Linked Savings Scheme or ELSS is one of the best tax saving mutual funds available that allows one to invest across both dividend and growth options. Here are some of the key features of investing in ELSS funds: –

• Dual Benefits – By investing ELSS, you can avail dual benefits of tax benefits as well as wealth creation. You can claim tax deductions of up to Rs. 1.5 lakh. A major portion of ELSS investment are allocated to equity and therefore have the potential to deliver high returns.
• Low Lock-in Period – The lock-in period for a ELSS investment is 3 years.
• Minimum Investment – As an investor, you can allocate as low as Rs. 500 towards Systematic Investment Plans (SIPs) in ELSS.
• Mode of Investment – Investors have flexibility to choose between SIP and lump sum. You can pick the option that best suits your financial requirements.
• Taxation – After the completion of lock-in period, the long term capital gains (LTCG) of up to Rs. 1 lakh every year from ELSS mutual funds are tax-exempt. Moreover, LTCG above 1 lakh is taxed at 10%.

Benefits of Tax-Saving Mutual Funds

Investments made under tax-saving mutual funds such as ELSS qualify for tax deduction of up to Rs. 1.5 lakh every financial year under section 80C of the Income Tax Act of India. These funds carry one the shortest lock-in periods among all 80C investments. These mutual funds also offer the option to invest via SIP i.e. (weekly, monthly, quarterly, half-yearly, or yearly) or as a lump sum in one go.

Tax-saving mutual funds have the potential to generate high returns in the long term as most of their amount is invested in equity-linked instruments. They can help you fulfil your long-term financial objectives while letting you save on taxes.

Key Takeaways

• Tax saver mutual funds allow investors to lower their taxable income and pay fewer taxes. 
• Best tax saving mutual funds invest through the ELSS scheme that invests in equity-oriented stocks. 
• Since there are numerous tax saving mutual funds, it is vital to choose the best tax saving mutual fund 2021 for greater profitability. 
• You can invest in tax saver mutual funds using the SIP method for small investments at regular intervals. 

How to Invest in Best Tax Saver Mutual Funds?

As an investor, you can invest in the tax saving mutual funds in the same way you do in any any mutual funds. The simplest way is to invest through online investment services. People have the flexibility to invest via Systematic Investmet Plans (SIPs) or as a lump sum route. The regularity and discipline of a SIP can help reduce the risk to your capital.

One can start in investing in SIPs with an amount as low as Rs. 500 in an ELSS funds. Moreover, you can claim tax benefits of up to Rs. 1.5 lakh and you are free to invest as much as you like.

Who Should Invest in Tax Saver Mutual Funds?

Tax saver mutual fund can be suitable for any taxpayer who can take the risk of investing in a equity-oriented instrument. ELSS funds in particular are best suited for salaried individuals as they have a monthly source of income and have to make tax saving investments every year. It is very convenient for them to invest in ELSS through SIP as they can benefit on the basis of ruppee cost averaging.

Factors to Consider While Choosing Tax Saving Mutual Funds

Here are some of the factors you need to keep in mind while choosing a tax saver mutual fund: –

• Performance History – Before investing in a tax saver mutual funds, make sure to analyse their past performance. It can help you in making an informed decision. However, it should not be the only factor to look at. Make sure to check other factors as well.
• Expense Ratio – The expense ratio of an investment refers to the amount that goes into managing the funds. An an investor, you need to carefully consider expense ratio as it can have a direct impact of the returns generated. The higher the expense ratio, the lower would be the returns and vice-versa. In case two different funds have a similar track record and asset allocation, it is suggested to consider the fund with lower expense ratio.
• Size of Funds – Funds that perform better are generally favored by the investors and therefore have a larger assets under management compared to underperforming funds. Investors must take the size of funds into consideration as it can be a good indicator.

How is the Capital Gains on ELSS calculated?

The ELSS investments come under Long-Term Capital Gains (LTCG) with the lock-in period of 3 years. It offers an added benefit of tax exemption. After you get the deduction of Rs. 1.5 lakh, the amount will be taxed at 10% without any indexation benefit, which is the advantage of adjusting the principal amount after the effect of inflation.

To understand this better, let us take an example. If you have invested Rs. 3 lakh in the ELSS scheme. After the completion of lock-in period, you can redeem the fund at 3 lakh where Rs. 1.5 lakh will be exempted from tax.

Therefore, taxable income after deducting Rs. 1.5 lakh from the Rs. 3 lakh equals Rs. 1.5 lakh. As per the LTCG scheme, you will be required to pay a tax on the amount after Rs. 1 lakh has been deducted, which comes to Rs. 50,000. Now, this sum is taxed at 10% under the LTCG scheme.

Conclusion

The money sitting in your bank account is going through inflation which is lowering its actual value. What you could buy for 1,000 rupees some years ago is not possible now, and that is why earning returns higher than the inflation rate is of critical importance. 

Hence, it is the need of the hour that you find the best tax saving mutual funds by going through the mutual funds under 80C. The best tax saving mutual fund for tax benefit will allow you to receive steady, risk-managed returns along with multiplying your invested corpus over time.

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Also Read: Learn how to Invest in SIP