How to save taxes by investing in mutual funds

Published on: Thu Aug 03 2023

If you've ever been stumped at how to save more on taxes, don't worry. You're not alone. Many individuals often overlook the idea of using mutual funds for tax saving purposes. This article will guide you through understanding how mutual funds can be an effective tax-saving instrument.

Mutual Funds: A Brief Overview

Mutual funds are investment vehicles that pool money from various investors to invest in a diverse portfolio of securities such as stocks, bonds, or other assets. They offer several advantages, such as professional management, diversification, and liquidity. But perhaps one often overlooked advantage is their tax efficiency.

Mutual Funds and Taxes: The Connection

The relationship between mutual funds and taxes can be tricky. However, understanding it can open doors to potential tax-saving opportunities. The primary means of saving tax through mutual funds is through certain schemes known as Equity Linked Saving Schemes (ELSS) or through long-term capital gains advantages.

Equity Linked Saving Schemes (ELSS)

ELSS are tax-saving mutual funds that allow individuals to save tax under section 80C of the Income Tax Act. Investments up to a certain limit in ELSS are deductible from your gross total income before arriving at taxable income.

An ELSS fund has a lock-in period of three years, the shortest among all tax-saving instruments under section 80C. The dividends received and the capital gains on redemption of units after the lock-in period are also tax-free. These features make ELSS an attractive option for investors looking for tax savings coupled with good returns.

Long Term Capital Gains (LTCG) Advantage

Another avenue for tax-saving through mutual funds comes from long-term capital gains. When you hold mutual fund investments for over a year (in the case of equity mutual funds) or three years (in the case of debt mutual funds), the profit made is considered a long-term capital gain. In many jurisdictions, long-term capital gains are taxed at a lower rate than regular income or short-term gains.

Understanding the Dividend Distribution Tax (DDT)

Before 2020, dividends distributed by mutual funds were subject to Dividend Distribution Tax (DDT), paid by the mutual fund house before passing the dividends to investors. However, changes in tax laws in many countries have shifted this tax to investors, where the dividends are now added to the income of the investor and taxed at their income tax slab rate. Choosing a growth option over a dividend option in mutual funds can help save this tax.

Indexation Benefits on Debt Mutual Funds

One of the best strategies to save tax is by investing in debt mutual funds. If you hold these funds for more than three years, you will be eligible to claim indexation benefits. Indexation takes into account the effect of inflation on your investment. It adjusts the purchase price, which reduces the total taxable amount of your long-term capital gains.

Tax Loss Harvesting

This strategy involves selling a security that has experienced a loss. By realizing—or "harvesting"—a loss, investors are able to offset taxes on both gains and income. The sold security is then replaced by a similar one, maintaining the optimal asset allocation and expected returns.

Conclusion

Investing in mutual funds is not just about saving for your future, but it's also about smart tax planning. Understanding the intricate relationship between mutual funds and taxes can help you make better decisions, allowing you to save on taxes and maximize your wealth. It's crucial to consult with a financial advisor or tax professional to understand the best strategy for your unique situation. With the right knowledge and professional guidance, mutual funds can serve as a powerful tool in your tax-saving arsenal.

Please remember that the taxation rules mentioned are subject to change as per the tax laws and it's essential to stay updated or consult a tax advisor to comprehend the latest norms.

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