How to reduce your tax outgo by investing in mutual funds?

This is a guest post by Manikaran Singal is a Certified Financial Planner and runs a personal finance blog goodmoneying.com

Mutual funds are that investment vehicle which helps in investing across various asset classes like equity, debt, and gold through professional management. You are wrong if you say that you invest in mutual funds since you don’t invest in mutual funds, you invest through mutual funds. The type of asset which a particular fund is investing in defines the category like Equity, Debt Mutual fund, Gold Mutual fund etc.

You may invest in any asset class directly if you think you have expertise in it or you may select mutual funds route. Direct investment products include purchasing shares through demat accounts, buying NCDs, investing in Public Provident Fund, Endowment LIC policies, National savings certificate etc. and for short to medium term – bank savings account, bank fixed deposits, Corporate fixed deposit etc., buying gold in the form of jewellery or coins/bricks etc.

Selecting mutual funds for investing has its own advantage like professional management, diversification, economies of scale etc. but besides all this there’s the major advantage it has is of taxation.

Let’s first understand Taxation in Mutual funds

Mutual funds generate 2 types of income – dividends and capital gain.

Capital Gains

When the holding period in a particular mutual fund is one year or less and you book some gain/loss in this period then that would be called as Short term capital gain/loss and if the holding period is more than 1 year than it will be called as Long term capital gain/loss. When there’s loss, no question arises for taxation, besides setting it off.  But gains will be taxed differently with different category of fund.

Tax rates (2012-13)

Long term Capital Gains (units held for more than 12 months)

Individual/HUF NRI*
Equity Oriented schemes NIL NIL
Other than equity schemes 10% without Indexation or 20% with Indexation whichever is Lower +3% cess 10% without Indexation or 20% with Indexation whichever is Lower +3% cess
Without Indexation =10.30% =10.30%
With Indexation =20.60% =20.60%

 

Short Term Capital Gain (units held for less than 12 months)

Individual/HUF NRI*
Equity Oriented scheme 15%+3% cess 15%+3% cess
=15.45% =15.45%
Other than equity scheme 30%#+3% cess 30%#+3% cess
=30.90% =30.90%

# assuming Investors falls in highest tax bracket

  • NRIs will be subjected to TDS in case of Long/Short term capital gain.

 

Dividends

Unlike interest in debt investments which is completely taxable (with few exceptions), dividend in debt Mutual funds are tax free in the hands of investor. But yes, they are subjected to Dividend distribution tax which fund house pays at their end. Dividends in equity Mutual funds are tax free.

Dividend tax rates

Individual/HUF NRI
Equity Mutual funds NIL NIL
Other than equity Mutual funds NIL NIL

 

Dividend distribution Tax

Individual/HUF NRI
Equity Mutual funds NIL NIL
Debt Schemes 12.5%+5%surcharge+3%cess 12.5%+5%surcharge+3%cess
=13.519% =13.519%
Money market/Liquid schemes 25%+5%Surcharge+3% cess 25%+5%Surcharge+3% cess
=27.038% =27.038%

 

You all must know that the interest rates in most of the debt investment options have been deregulated by the government. Gone are the days when you receive fix rate of interest in PPF for complete tenure. Almost all Post office savings rate will be reviewed and announced every year. And even in savings account which used to give 4% fixed rate has been deregulated. The decision is left to the market forces which will decide the interest rate. Now it becomes inevitable for the investor to optimise the overall return to look for other suitable investment options. And you won’t find a better alternative to mutual fund investments. If you understand the various types of mutual funds, it’s working structure and which fund to be used and when you can generate a good tax efficient return.

Understanding How Mutual funds generate returns

Banks and AMCs (Asset management Companies) or as popularly called as Mutual fund houses both are very important elements of Indian Financial services industry. Both are in the business of mobilising the savings and investments of retail and corporate sector and diverting the same into various short and long term investments. Banks are mainly into lending business so you may say that they deal only in Debt Instruments, but Mutual funds are into investments so they deal with all assets like Equity, Debt, and Gold etc.

This is explained to make you understand that difference in return of 2 product of same style is because of management and inherent expenses.

Tax efficiency through Mutual funds

  1. Liquid/ Ultra Short term  funds Vs. Saving account:

Returns in Liquid/ultra short term fund will always be more than the saving bank rates. The difference in the management and expenses as explained above can easily be pointed out from the fact that some banks are offering rates of 6-7% while many are still on the old rates. It may also be a business compulsion. But in Mutual funds there’s a CAP on overall expenses. That’s why they generate the same returns from short term debt market and distribute among its investors after deducting the expenses. Besides return the major advantage is also of taxation. If you park your funds in saving account whatever interest you will get (above Rs 10,000/-) in a particular year will be added in in your total income and taxed accordingly, but if you invest in Ultra short term/ Money manager funds then you may opt for dividend reinvestment option and reduce your tax outgo. Current account holders don’t get any interest in their account, so they can also use this to the full.

2.     Fixed Maturity plans Vs. Bank Fixed deposit:

Interest on bank Fixed deposit is fully taxable , but if you invest in Mutual funds FMPs then the maximum tax that you have to pay on the gain is 10.30%. (Read : Bank deposits Vs debt funds)

3.     Long term debt funds vs. PPF:

Now when PPF has been handed over to market forces, your portfolio requires active management and a combination of PPF and long term debt products. When interest rates starts falling PPF rates will go down but your long term debt investments will help you generate more by playing with duration due to the inverse relation between interest and bond prices. And more returns can be set off with the indexation benefit and thus less tax.

4.     Mutual funds MIP vs. Senior Citizen Plan/ Post Office MIP

You may also reduce considerable on your tax payment by diversifying your regular return fully taxable investments into Mutual funds MIP and taking dividend payment option and advantage of Dividend distribution tax.

5.     Gold ETF Vs.  Physical gold

Besides offering advantage of Liquidity, Authenticity, affordability etc. gold ETF has its tax advantages also. Profits from gold ETFs are taxed as Short /Long term capital gain just like debt mutual funds, whereas profit out of Physical gold comes in long term capital gain only after 3 years of holding. Paper gold also does not attract Wealth Tax.

Mutual funds are very tax efficient products. But it should be used with caution and under some guidance. Wrong product chosen at wrong time and without giving reason to your investment has the potential to destroy your savings and overall returns. So sit with your planner/advisor, decide onto your goals and requirements and design the required portfolio.

11 thoughts on “How to reduce your tax outgo by investing in mutual funds?

  1. Good work Manikaran. I was not under an impression about we can benefit some tax through the mutual funds also other than ELSS. Now it makes more sense to me when I derive a comparison calculation.

    Thanks.

    1. Wow one heck of a complicated scheme. I’m not sure the benefits outweigh the calculations etc. I’ll have to read this in detail and will do a post next week on this. Thanks for the link Krishna.

    2. Krishna, on very simple note this is a tax saving scheme announced by govt in budget 2012-13 ,but final guidelines are out recently. This scheme is for the first timers in equity market whose total income is less than 10 lakh. The maximum investment one can make is Rs 50,000/- and will get the the tax benefit of 50% of the contribution.

      Though Mutual funds are also allowed to launch some scheme under RGESS, but they are yet to come up with the suitable plans.

  2. Thanks for the very informative article on benefits of investing in mutual funds. One term I find that appears many times but I do not understand is indexation. What is the meaning of indexation and how is it calculated? i have also read that there are tax saving mutual funds – are these different from the regular mutual funds, where can i learn more about them? any pointers will be much appreciated.

    1. Indexation term has come from Cost Inflation Index which is a government notified factor and announced every year by government of India. Under Indexation you are allowed to inflate the cost of your assets by the CII factor which helps to reduce the net taxable profit allowing you to pay lower capital gain tax. The Idea behind is inflation. Say for e.g you have purchased a debt fund/ land/gold in Year 2000 for Rs 10 lakh and sold it in 2010 for Rs 20 lakh. Now in actual you have made a gain of Rs 10 lakh , but if you index it with the CII figures of Year 2000-01 (406) and Year 2010-2011 (711) then the cost of Land gets inflated to Rs 17.51 lakh and thus profit gets reduced to Rs 2.49 lakh. Hope i am clear now.

      Regarding your other query ..yes there are tax saving mutual funds which are termed as ELSS (Equity Linked saving scheme) investing into which will help you save tax u/s 80C. Structure wise they are same like other equity mutual funds but they are specified as tax saving instruments.

  3. With amendment in section 112 from AY 2013-14, whether MF units need to be considered part of unlisted securities? Although this was not the intention if one reads Explanatory Memorandum (Finance Act 2012)

    However, MFs are treating so and therefore, indexation benefit is not made available for NRI if there is long term capital gain on debt MF units. They deduct TDS @10% without considering indexation benefit.

    As per my view based on last proviso under 112, for NRI also, indextion is available for long-term gain on debt MF units. So one can claim refund of TDS by filing return with indexed cost of acquisition
    Please advise

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