Tax-exempt mutual funds: All you need to know

Applicable taxes on returns are a crucial consideration for investors when choosing a mutual fund. This may prompt investors to wonder whether there are any tax-exempt mutual funds or tax-saving mutual funds.

The Equity Linked Savings Scheme emerges as a beneficial investment avenue in this regard. ELSS funds are tax-exempt mutual funds that provide dual benefits to investors —capital appreciation potential and tax savings up to a certain limit. But the key to optimise investment outcomes is to understand the nuances of these funds.

Read on to learn more about these tax-saving mutual funds and whether they are suitable for your financial goal.

• Table of contents

• What are tax-exempt mutual funds?
• Optimising tax benefits with tax-exempt mutual funds
• How do tax-saving mutual funds work?
• How can I find tax-exempt mutual funds?
• Features of tax-saving mutual funds
• Benefits of tax-saving mutual funds
• Things to consider before investing in tax-saving mutual funds

What are tax-exempt mutual funds?

ELSS is the only category of mutual funds in India that offers tax exemptions. These funds qualify for tax benefits under Section 80C of the Income Tax Act, 1961 (Old Regime). Under this Section, investments of up to Rs. 1.5 lakh in a financial year in select avenues can be deducted from the investor’s taxable income, thereby reducing their overall tax liability. Investment avenues listed under Section 80C of the Income Tax Act, 1961, include Public Provident Fund, National Savings Certificate, Sukanya Samriddhi Yojana etc. The combined exemption limit for all these is Rs. 1.5 lakh in a financial year.

Key characteristics

• Investments in ELSS tax saving funds are eligible for tax deductions
• These funds primarily invest in equity and equity-related instruments
• They have a mandatory lock-in period of three years, which is the shortest among all instruments eligible for deduction under Section 80C of the Income Tax Act, 1961.
• Capital gains generated from these funds qualify as Long-Term Capital Gains (LTCG) because of the three-year lock-in period). LTCG tax rates are lower than STCG rates. LTCG of up to Rs. 1.25 lakh in a financial year is tax-exempt. Thereon, they are taxed at 12.5%. STCG is taxed at 20%, with no exemptions.

Optimising tax benefits with tax-exempt mutual funds

To make the most of tax benefit in mutual funds, it’s crucial to align your investment strategy with your financial goals and tax planning needs. Here’s how you can do it:

1. Start early: Investing early in the financial year allows you to spread your contributions across months, reducing financial strain during the last-minute rush.
2. Leverage SIPs: Systematic Investment Plans (SIPs) in ELSS tax saving funds enable disciplined investing while taking advantage of rupee cost averaging.
3. Diversify within ELSS: Some ELSS funds focus on large-cap stocks for stability, while others lean toward riskier mid-cap or multi-cap strategies for higher return potential. Choose based on your risk appetite.
4. Plan beyond taxes: While saving taxes is a key benefit, focus on long-term wealth creation by assessing fund performance, expense ratios, and portfolio allocation.

How do tax-saving mutual funds work?

Tax-saving mutual funds or ELSS funds work by pooling money from investors and investing it primarily in equity markets. Here’s how they function.

• Investment allocation: ELSS funds allocate at least 80% of their corpus to equity and equity-related instruments across sectors and market capitalisations.
• Lock-in period: Investments in ELSS come with a mandatory three-year lock-in period, meaning you cannot redeem or withdraw your units before this period ends.
• Returns: Returns from ELSS are market-linked and depend on the performance of underlying stocks. However, they have the potential to offer wealth-building potential in the long term through investments in equities and equity-related instruments.
• Taxation: Gains up to Rs. 1.25 lakh per financial year are exempt from taxes under LTCG rules; capital gains exceeding this amount are taxed at 12.5%.

How can I find tax-exempt mutual funds?

As mentioned, ELSS is the only tax-saving mutual fund. To identify a suitable ELSS fund to invest in, you can follow these steps:

• Identify a scheme: Several mutual fund companies offer ELSS funds. Compare expense ratios, investment strategy, fund manager details, risk-adjust return metrics and other relevant information to select a suitable one.
• Identify an investment mode: You can invest directly through the Asset Management Company’s website or through a distributor. You can also invest through an aggregator.
• Choose SIP or lumpsum: Systematic Investment Plans (SIPs) allow you to invest a fixed amount in regular intervals (daily, weekly, monthly etc.) in a mutual fund scheme of your choice. This can help you systematically invest in ELSS to reach the tax exemption limit in each financial year. Payments can be automated, so your tax saving investments will automatically happen every year until you stop your SIP. Alternatively, you can make an annual lumpsum contribution.

Features of tax-saving mutual funds

ELSS mutual funds have the following features:

• Equity focused: At least 80% allocation to equities ensures potential for high returns.
• Lock-in period: The three-year lock-in encourages discipline and mitigates impulsive withdrawals.
• Tax benefits: Investments qualify for deductions of up to Rs. 1.5 lakh annually under Section 80C of the Income Tax Act, 1961.
• Flexibility in investment amounts: You can start investing with as little as Rs. 500 in general through SIPs or lumpsum. It would be beneficial to align your investment amount to the amount you need to save to reach the tax-exemption limit.
• Professional management: Managed by experienced fund managers who actively allocate assets based on market conditions.

Benefits of tax-saving mutual funds

Investing in this tax-saving mutual fund offers several advantages.

1. Dual benefits: Save taxes while building wealth in the long term through equity investments.
2. Shortest lock-in period: Compared to other options under Section 80C of the Income Tax Act, 1961, ELSS has a significantly shorter lock-in period. For example, PPF has a 15-year lock in, while NSC has a 5-year one.
3. Better long-term return potential: Historically higher returns compared to traditional fixed-income instruments like FDs or PPFs. *Past performance may or may not be sustained in the future.
4. Inflation beating growth potential: Equity exposure can help combat inflation over time.
5. Ease of investment: Flexible SIP options allow small monthly contributions.

For instance, an investor contributing Rs. 12,500 every month in an ELSS fund through an SIP can fully use the Rs. 1.5 lakh Section 80C of the Income Tax Act, 1961 limit while potentially earning inflation-beating returns over time. Salaried employees may also have other tax benefits under Section 80C of the Income Tax Act, 1961 (such as Employee Provident Fund contributions), so they can accordingly determine how much more they need to invest in ELSS and other avenues.

Things to consider before investing in tax-saving mutual funds

Before committing to an ELSS investment, consider the following.

• Investment horizon: Ensure you can stay invested for at least three years without needing liquidity.
• Risk appetite: Assess whether you are comfortable with market-linked risks associated with equity investments.
• Expense ratio impact: Opt for funds with lower expense ratios for better net returns over time.
• Diversification needs: Ensure that your overall portfolio also has some relatively low risk avenues such as fixed deposits and debt mutual funds. Also make sure you have some liquid investments to meet sudden cash needs.

Conclusion

While most investors focus solely on the tax-saving aspect of ELSS, it’s equally important to consider their potential for long-term wealth creation through disciplined equity exposure. Strategic planning can amplify wealth creation potential as well as tax efficiency when leveraging the power of ELSS tax-exempt mutual funds effectively.

FAQs:

How do I know If my mutual funds are tax-free?

The only mutual funds with tax benefits are the Equity Linked Savings Schemes (ELSS). ELSS mutual funds are one of several investment options eligible for tax exemption under Section 80C of the Income Tax Act, 1961 (Old Regime). Investments of up to Rs. 1.5 lakh made in ELSS funds and other avenues under this Section can be deducted from the investor’s annual taxable income.

Additionally, long-term capital gains of up to Rs. 1.25 lakh from ELSS and other mutual funds held for over a year are tax-exempt.

Which mutual funds are exempt from income tax?

ELSS is the only mutual fund category eligible for tax exemption under Section 80C of the Income Tax Act, 1961. Investments of up to Rs. 1.5 lakh made in avenues listed under this Section can be deducted from an individual’s taxable income.

What Are Tax-Exempt Mutual Funds?

The only tax-exempt mutual fund is ELSS, which offers dual benefits – tax savings under Section 80C of the Income Tax Act, 1961, and potential long-term capital appreciation through equity market exposure.

Why should I consider investing in tax-exempt mutual funds?

You may consider investing in ELSS mutual funds if you seek tax benefits along with better long-term growth potential and a shorter lock-in period than other tax-saving avenues. However, ensure that you have a high risk appetite.

What types of securities do tax-exempt mutual funds Invest In?

ELSS primarily invests in equities across large-cap, mid-cap, and small-cap stocks (equities must comprise minimum 80% of the portfolio) but may also include some debt instruments for diversification.

How do I determine if a mutual fund is tax-exempt?

If your mutual fund falls under the ELSS fund category, it qualifies for tax exemption under Section 80C of the Income tax Act, 1961. Other mutual fund categories do not offer tax exemption.

How do I compare different tax-exempt mutual funds?

Compare based on historical performance (3-, 5-, and 10-year returns), expense ratios, risk-adjusted return metrics, investment strategy and portfolio composition. However, do note than past performance may or may not be sustained in the future.

What Is the significance of yield on tax-exempt mutual funds?

The term yield is more directly linked to debt mutual funds and pertains to the income generated from the underlying fixed-income securities in the portfolio. In the context of ELSS funds, the technical definition of yield may not apply. However, some investors may use the term yield synonymously with returns.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.