Why investing in tax-saving mutual funds is a good idea

As the name suggests, tax-saving mutual funds offer the benefit of tax saving to the investor. Also known as Equity-Linked Savings Scheme (ELSS), this mutual fund scheme primarily puts in money in the stock market. One reason why several investors prefer this financial instrument is because it has the shortest lock-in period, i.e; three years. In simple terms, this also means that even if you would like to, you can’t sell your investment until its maturity date.

How does it help to save tax?

Since ELSS is regarded to be a popular way of tax-saving, let’s understand how it does so. Investments made in an ELSS (up to a maximum of Rs 1.5 lakh per annum) can be considered for income deductions under Section 80C of the Income Tax Act. What this essentially means is that whatever amount you put into an ELSS can be deducted from your income; this means your taxable income reduces.

Let’s take an example to put things into perspective. For instance, say Arjun has a taxable income of Rs 12 lakh a year - this means he falls under the 30% tax bracket. He wants to invest and at the same time, save tax. That’s a big reason why he decides to invest Rs 1.5 lakh in an ELSS fund, which brings down his taxable income to Rs 10.5 lakh. This also means he can save Rs 46,800 every year* (taking the current 4% educational cess on tax. If we include the cess, the tax saving per annum would come to 31.2% of Rs 1.5 lakh or Rs 46,800).

Is it beneficial to go for ELSS?

When you earn a fixed salary every month, there is a section of your earnings that goes into fixed income through Provident Fund deductions. In case you want to balance that, you can consider ELSS. At the end of the day, ELSS works well as a tax-saving instrument that will deliver potentially high returns. Some may argue that Unit Linked Insurance Plans and the National Pension Scheme also work in the same way, but their lock-in period is much more.

ELSS is also a great option for first-time investors - they can get a taste of investing in equity and can consider it as a learning experience for their future experiences. While some may say that equity comes with its own set of risks, which is true; the idea is to invest over a long period and not just short-term. In case you invest for about five to seven years, it will help you achieve your goal of wealth creation.

You can start off by investing in monthly Systematic Investment Plans (SIP), instead of making lump sum payments. This also helps you build a safety net, especially when the market is going through a low phase.

Advantages of ELSS

Here are a few advantages of investing in an ELSS:

Shortest lock-in: If you compare ELSS with other financial instruments, it has the shortest lock-in period of three years. Tax-saving fixed deposits have a five-year lock-in, while PPF has a 15-year period to mature. This makes ELSS highly liquid.

Potentially higher returns: Other 80C investments like the PPF or FDs do not deliver returns the way an ELSS does, but remember it works well for a medium to long-term investment horizon.

Beneficial post-tax returns: Except PPF and NPS, ELSS certainly offers better post-tax returns - long term capital gains of up to Rs 1 lakh a year from ELSS mutual funds are exempt from income tax, and long-term capital gains above Rs 1 lakh are taxed at 10%.

Simple and hassle-free: You can invest in an ELSS fund without any hassle (you can start off through SIPs). Also, it isn’t necessary that you have to invest in them with a horizon of just three years; in fact, doing so for a longer period will yield better returns.

The bottomline

Remember the above-mentioned pointers when you plan to invest in an ELSS fund. Of course, they work well when it comes to saving tax and also have the potential to deliver great returns in the long run - but remember, you must also have an appetite for risk to face market fluctuations. Secondly, do not let the shortest lock-in period advantage be the only reason for you to invest. Make sure you take an informed decision - after all, being educated is being empowered.