#MutualFundKickstarter: Mutual Funds – Every Investor’s Tax Planning Tool
Published On: 21-Jun-2018

It is a fine balance every investor needs to achieve. We need to pay the taxes due from us. Yet, we need to plan our taxes especially on our investments. The idea is to make more money available for growth so that we save ample amounts for future needs. But how does one do that?

Welcome to mutual funds whose various offerings help you do efficient tax planning. If you are wondering how, we will tell you all about it, but first, a brief primer on impact of tax on investments.

Tax Primer for Investments

For a simplified picture, one can demarcate the impact of tax on investments into three stages. First, when you choose the investment. Here, you may not be taxed but you get tax benefits. It is important to look out for such investments and benefit from them.

Second stage where tax impacts investments pertains to its returns. Certain forms of returns like interest increase your tax outgo while others like dividend are tax free in your hands. The third point of tax impact on investments is at maturity or during partial withdrawals.

Different investments have different tax treatments. However, if you are invested in the right investments, you are likely to plan your taxes far better. Let’s look at these aspects in some more detail.

Taxation when you invest

Some investments provide tax benefits for the investment amount at the time you invest. Among mutual funds, equity linked savings scheme (ELSS) and mutual fund retirement plans provide annual tax deduction of upto Rs 1.5 lakh under Section 80C. Being an equity investment, it also provides a great opportunity to start accessing long-term growth of money that typically accrues from equity investing over 8-10 years, or more.

Tax on Returns

A cornerstone of tax planning involves ensuring that tax on investment returns is as low as possible. This helps in ensuring that a greater amount of invested money is available after tax, to benefit from compounded growth i.e. growth based on progressively growing principal amounts. Here two are contrasting examples.

If you invest in a fixed deposit, you earn interest income. This effectively gets taxed at your relevant income tax rate. This can be high if you are in the highest 30% tax slab. At the same time, if you have invested the same amount in equities for more than one year, the appreciation of your investment, will be treated as long term capital gains and be tax-free.

Tax on partial withdrawal and maturity

“Slip between the cup and the lip” can happen when the tax impact on your maturing investments is more than it should be. Here, often the key is the period over which you have stayed invested.

Tax on equity funds

As we have mentioned, if you stay invested for more than one year in an equity investment be it equities themselves or equity mutual funds, the capital gains are taxed at 10%. However, for a period of less than a year, you pay 15% of the gains as short term capital gains tax.

Tax on debt funds

For debt investments, including debt mutual funds, the key is whether you have remained invested for 3 years or more. For any period less than 3 years, your capital gains get added to your income for tax purposes and get taxed.

The tax treatment is different for periods of more than 3 years. Here, capital gains are treated as long term capital gains, and you pay tax of 20% on the gains adjusted for inflation. This adjustment for inflation, or inflation indexation, effectively enhances the cost of acquiring the investment by factoring in the inflation during the period of investment. Consequently, you pay less in tax.

SWP for tax planning

In many cases, you may not fully exit the investment. Or you might want to do it regularly. This is typically the case when you need regular income, be it to meet your child’s college fees or in retirement. Here, you need to ensure that the tax impact doesn’t lessen the amount you effectively get at hand. Here too, mutual funds offer the tax efficient facility of systematic withdrawal plans (SWP). Here’s how you can use SWP.

About 2-3 years from the time you need the money, you need to gradually move the money away from higher risk investments like equity funds to lower risk, debt funds. For regular income, your debt fund units are sold at regular intervals of time to provide you with the redemption proceeds regularly.

Tax impact

Depending on whether the units were bought before or after 3 years, capital gains tax needs to be paid in SWPs. For less than three years, the capital gains get added to your income and after three years it is long term capital gains tax of 20% with indexation benefits. This means that SWP provides a tax–efficient way of withdrawing money for those in the higher income tax slabs. Of course, SWP can also be used to create regular payouts for equity funds and tax rules for equity funds apply there.

Now, after this brief primer, let’s look at how mutual funds can be effectively used as a tax planning tool for three typical investor profiles.

Early Career Tax Planning

Early on in one’s work life, when expenses are in hot pursuit of regular pay, tax planning for investments can help direct tax savings towards supplementing the savings for major long term goals . The key is to make investments that provide tax deductions as well as allow the money to grow briskly. It is here that equity linked savings schemes (ELSS) fit the bill, combining annual tax savings under Section 80C with long term growth of money.

ELSS: The first investment

In effect, ELSS can be actively considered to be the first equity investment that can initiate efforts towards making progress towards important long term needs like retirement. Tax deduction at the time of investment and the tax exempt status for its returns and maturity amount makes it an attractive go to investment.

People at this stage of life are typically hard pressed to spare money. The smart approach is to make the investment in small amounts through systematic investment plans (SIPs). With SIPs, one can ensure the tax saving investment happens regularly even before any money from the pay is spent.

Double Income, Young Couples

ELSS for major financial goals

At this stage of life, the combination of tax saving with long term growth of money, works well both for individual and family requirements in the long term. This means these families need to tap the tax saving and growth combo of ELSS. If the ELSS investments haven’t been initiated yet, this is the time to kickstart them.

Separate investments in ELSS can be earmarked for major family requirements for the future, be it children’s higher education or retirement. To ensure regular investment for each major need, ELSS investments can be made through SIPs.

Retirement plans for retirement needs

Mutual funds also provide retirement plans that help you save ample amounts for retirement. Like ELSS, these plans also provide annual tax deduction of up to Rs 1.5 lakh under Section 80C. Thus, besides tax planning, they help you augment your retirement savings from other sources of retirement savings like provident fund. Further, like ELSS, one can invest in them regularly through SIPs.

Reaching Financial Goals

SWP for child’s college fees and retirement

We need to be mindful of the impact of tax on returns and withdrawals. How do you do that when you need regular amounts of money to meet needs like paying for child’s college fees or creating regular retirement income?

This is where systematic withdrawal plan (SWP) comes in handy.

About 2-3 years from the time you need the money, gradually move the money away from higher risk investment like equity funds to lower risk, debt funds. With the help of SWP, you can get regular payments made out of this savings. We have already discussed how SWP from a debt fund investment that’s more than 3 year old, is more tax efficient.

It is abundantly clear that apart from the numerous advantages that mutual funds provide, they are also a great tax planning tool. What’s more, with their help, the benefit of tax planning can be reaped at various stages of one’s life and major future needs successfully met.

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Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.