Investing in a mutual fund: keep the tax factor in mind

Mutual fund investments have become a hot thing among young investors who are capitalizing on the tool as a long-term savings option with relatively good returns coupled with tax savings. They don’t care about the risk factor associated with the great returns promised by mutual funds if they come with tax-saving tools. But should you consider tax-saving mutual funds or equity-linked mutual funds (ELSS) as an investment option or keep the two separate?

Experts believe that taxes are only secondary and should not be the main criterion when you are in the market looking for a good fund for your savings. The key factor in choosing a mutual fund is whether the fund category is right for your financial goals.

ELSS or investing in tax-saving mutual funds is an advantageous mode of saving tax under Section 80C of the Income Tax Act. Over the years, investing in ELSS has generated an annualized return of over 14% over the past 10 years and allows you to view a tax refund for an investment of up to 1.5 million. They are pure equity funds and quite similar to flexi-cap funds in their investment mandate. In ELSS, a fund manager has the flexibility to invest in companies of different sizes and sectors in any proportion. But the benefits of ELSS come with an endorsement.

Investment in ELSS has a mandatory lock-up period of three years. So even if you make a Monthly Systematic Investment Plan (SIP) or a lump sum investment for tax saving purposes, you will not be able to redeem the invested amount for the next 3 years. For example, if you had invested 5,000 per month via a SIP in May 2019, the three years for the first SIP payment will end in May 2022, for the second in June 2022, for the third in July 2022 and so on. So if you don’t want to forget about the money you save every year and only come back for the returns after 8-10 years, you’ll be a happy investor, but if you plan to redeem the amount invested in phases to fulfill your goals in the short term, ELSS is not what you should consider. In such a scenario, you can opt for a flexi-cap fund which would be free to redeem your money in case of an emergency or if something goes wrong with the fund.

You should also consider paying tax on your investment earnings when deciding on your mutual fund strategy. Previously, if you redeemed your mutual funds after a year, it would not have attracted any tax, whereas now you may have to pay 10% tax on any gains above 1 lakh. So to avoid tax and save yourself from market volatility, long-term equity mutual funds are the best bet for you.

However, for a medium term horizon, you can go for a mix of equities and fixed income securities where the investment ratio would depend on several factors – if the target is tradable, how much risk are you willing to take , etc. If the objective is tradable, you may have a higher allocation to equities, otherwise have a larger share of fixed income securities. Capital gains of a non-equity fund after three years are taxed at 20% after benefiting from indexing. If sold within three years, the gains are added to your income and taxed according to the applicable bracket.

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Dolores W. Simon