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.
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)
|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|
Short Term Capital Gain (units held for less than 12 months)
|Equity Oriented scheme||15%+3% cess||15%+3% cess|
|Other than equity scheme||30%#+3% cess||30%#+3% cess|
# assuming Investors falls in highest tax bracket
- NRIs will be subjected to TDS in case of Long/Short term capital gain.
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
|Equity Mutual funds||NIL||NIL|
|Other than equity Mutual funds||NIL||NIL|
Dividend distribution Tax
|Equity Mutual funds||NIL||NIL|
|Money market/Liquid schemes||25%+5%Surcharge+3% cess||25%+5%Surcharge+3% cess|
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
- 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.