3 Reasons Why Mutual Funds Are One Of The Best Tax Saving Options

3 Reasons Why Mutual Funds Are One Of The Best Tax Saving Options

Tax saving mutual funds also known as ELSS mutual funds is equity mutual fund schemes which invest in a diversified portfolio of stocks with the objective of generating long term capital appreciation for investors over a sufficiently long investment horizon. Investors can get tax deduction of up to Rs 150,000 from their taxable income by investing in Tax saving mutual funds under Section 80C of Income Tax Act 1961. Therefore, by investing the maximum allowable amount of Rs 150,000 in a year, you can actually save Rs 46,350 in taxes (if your tax bracket is 30%).

While making investment in tax saving instruments, products like ULIPs, endowment policies, Public Provident Fund (PPF), National Savings Certificate (NSC) and tax-saving bank or post office fixed deposits may come first to the mind of the investors but tax saving mutual funds is fast gaining popularity because of the higher benefits it offers. Which are these benefits? We will discuss below –

Superior returns over long term period

As tax saving mutual funds invests in equities, it can be very volatile in the short term, but in the long term it easily beats all other asset classes (including fixed-income products like bank and post office tax saving deposits) by a very wide margin. A long term investor in ELSS can easily expect over 12% annualised returns while almost none of the other Section 80C investments presently deliver beyond 9% annualised returns. Let us have a look at the chart below to understand it better.

Approximate returns 13% 7-8% 6.5-7.5% 7-8% 7-8%
Lock-in period 3 years 15 years 5 years 5 years Till retirement
Tax on returns Yes # No Yes @ Yes @@ Yes (partially) ##

ELSS return – Source: CRISIL AMFI ELSS Fund performance Index – 3 years period (Dec17)

# Long term capital gain upto 1 Lakh in a year is tax free. Above 1 Lakh it is taxed at 10%

@ and @@ – Gains/ interest is added to income and taxed at the applicable tax rates

## 60% of the maturity corpus is taxable. Pension is also taxable.

In the above chart we can see that tax saving mutual funds can give superior return over other tax saving schemes. But what it means in the long term? Is the return difference really big in the long term? Let us again understand this by the following chart –

Investment value of Rs 100,000 after 20, 25 and 30 years
Returns Assumption Value of investment Value of investment Value of investment
  after 20 yrs (Rs) after 25 yrs (Rs) after 30 yrs (Rs)
6.50% 3.52 Lakhs 4.83 Lakhs  6.61 Lakhs
7.80% 4.49 Lakhs 6.54 Lakhs 9.52 Lakhs
13.00% 11.52 Lakhs 21.23 Lakhs 39.11 Lakhs

As we can see the return differential is quite huge in the long term between Tax saving mutual funds versus fixed interest tax saving investments.

Ideal for meeting long term financial goals

One of the biggest challenges for achieving long term goals is that we have limited time to save for our retirement, children education and their marriage etc. Even if we start retirement planning at the age of 30, we have just 25-30 years to save sufficient money and build a corpus that will last 25 to 30 years of our retired lives and also meet the interim goals. Therefore, it is very important how we allocate our tax saving investments as that can determine how big our long term goal corpuses can become!

When it comes to long term savings in India, traditionally we Indians relate it with investments in insurance policies, PPF, NSC and fixed deposits. However, the trend is changing with more people opting for marker linked investments. In the above example we have seen how big is the return differential between the fixed income investments versus the tax saving mutual funds. Let us see another example of wealth creation over the long term period is you save regularly in tax saving mutual funds over long term period.

Returns Return of Rs 1 Lakh invested in lump for various time periods
5 years 10 years 15 years 20 years 25 years
FD 7% 1,40,256 1,96,716 2,75,904 3,86,969 5,42,744
PPF 8% 1,46,933 2,15,893 3,17,217 4,66,096 6,84,848
Mutual Funds 12% 1,76,235 3,10,585 5,47,357 9,64,630 17,00,007

Please refer the above chart – For example – you have a retirement goal of Rs 2 Crores after 25 years. If you invest in tax saving mutual funds (assuming 12% returns) you can achieve the same by investing only Rs 10,539 per month. However, if you choose a fixed interest investment option (assuming 8% return) you will have to invest almost the double amount every month to achieve the same goal. Therefore, tax saving mutual funds could undoubtedly be one of the best tax saving investment option as it helps you in both – tax saving as well achieving the long term financial goals.

Tax efficient returns

Budget 2018 introduced long term capital gains (LTCG) at the rate of 10% for equity mutual funds including the tax saving mutual funds (LTCG in excess of Rs 1 Lakhs will be taxed at 10% from April 1, 2018 onwards). However, even after the re-introduction of long term capital gains (LTCG) tax for tax saving mutual funds; it still is one of the most tax friendly 80C investment options. Tax saver FDs are taxed as per the income tax slab rate of the investors. NSC interest is also taxed as per the income tax slab rate of the investor, but investors can claim 80C benefits on the accrued interest of NSC every year, except the final year of the NSC tenure.

Investors should just make a mental adjustment that 10 per cent of their long term capital gains get shaved off eventually. This means that an investor, who made, say absolute return of 40% in 3 years, has to pay 4 per cent of the original investment amount (assuming it is Rs 1 Lakh) as LTCG, provided the total gain in the year from all equity and equity related investment is over Rs 1 Lakh. Hence, while higher returns do get shaved off by a higher margin, the important point to remember is that the return potential of long term equity tax saving mutual fund investments is quite high.

We have seen how 3 compelling reasons make mutual funds as one of the best tax saving investment options. If you want to get superior return from your tax saving investments in order to achieve your long term financial goals, tax saving mutual funds could be a good option for you.

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