How do mutual funds offer better tax savings than other tax saving instruments?

Mutual funds How do mutual funds offer better tax savings than other tax saving instruments?

When it comes to tax saving, the natural choice for a long time was LIC and PPF. No longer! Today ELSS schemes of mutual funds have emerged as an important method of saving tax under Section 80C of the Income Tax Act. But what exactly is an ELSS? An Equity Linked Saving Scheme (ELSS) is an equity mutual fund with a tax benefit on investment. But there are some additional benefits on the ELSS scheme that may not be apparent. When we talk of tax benefits here we need to understand the tax benefit as distinct from the tax benefits on dividend and capital gains. Currently, dividends paid out by equity mutual funds are tax-free in the hands of the investor, although equity fund dividends are subject to 10% DDT effective Union Budget 2018. STCG (held for less than 1 year) is taxed at a concessional rate of 15%. LTCG was entirely tax free in the hands of the investor till March 2018. However, post April 2018, LTCG on equity funds attracts a flat tax of 10% above Rs.1 lakh per financial year. Where ELSS scores over other equity funds is in the special tax exemption under Section 80C.

What you need to know about Section 80C for ELSS…

Section 80C is a special exemption to tax payers up to Rs.150,000 per financial year. This section includes a lot other items like LIC premium, contribution to provident fund, payment of tuition fees for your children, principal repayment on your home loan and interest from long term bank FDs. Equity Linked Savings Scheme (ELSS) is part of this overall limit. An ELSS is like any other equity mutual fund with the only difference being that there is a compulsory lock-in of 3 years from the date of the investment. This Section 80C tax exemption substantially enhances the effective post-tax yield on an ELSS, which we shall see later. What is more important is that the ELSS has a lock-in period of just 3 years (lowest among 80C investments). In contrast, ULIPs and Long Term FDs have a 5-year lock in while PPF has a 15 year lock-in.

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ELSS enhances effective returns; and this how

To understand the power of ELSS, let us consider two investors who invest the same amount of money in an equity fund versus an ELSS fund.

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There are 3 important things to note here. Firstly, we are assuming that the investor B gets the full benefit of Rs.1 lakh out of the Section 80C limit of Rs.1.50 lakhs. Secondly, we have assumed that the Investor B is in the highest income bracket and we have considered 30% tax shield for simplicity (ignoring cess and surcharge). Thirdly, since the profit in the 3rd year is less than Rs.1 lakh, the profits will be full exempt from LTCG Tax.

What do we decipher from the above table? Investor B gets a 30% tax rebate in the year of investment which effectively reduces his outlay to Rs.70,000. This makes a big difference to the CAGR returns over 3 years, although both the funds have performed similarly. In fact, the Section 80C tax shield has enhanced CAGR returns from 20.6% to 35.8%.

Additional benefits that ELSS proffers on investors

    • ELSS not only saves tax but also forces the investor to take a long term view of investing. This is due to the mandatory 3-year lock-in. The investor cannot give in to the temptation of exiting early and equity funds work best in the long term.
    • It is also meaningful for fund managers. Often, fund managers in equity funds churn frequently due to pressure to book profits and keep the MTM position favourable. With a 3-year lock-in, the fund managers can afford to take a longer term view.
    • Since ELSS is equity and tax saving it becomes a very important and powerful vehicle for on-boarding first time investors on to the power of equities.
    • If the ELSS is done through the SIP route (and that is highly recommended), it helps the investor match outflows with inflows. But above all, it gives the benefit of rupee cost averaging, which brings down the average cost of holding over time.

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