How to Invest in Mutual Funds for Tax Benefits?

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  • 22 Dec 2023
How to Invest in Mutual Funds for Tax Benefits?

Mutual fund taxation is intricately linked to several influencing factors. Here are the key elements that determine the taxes imposed on mutual funds.

1. Type of Fund

One pivotal factor is the category of the mutual fund, such as equity mutual fund, debt fund, hybrid fund, each subject to distinct taxation rules.

2. Capital Gains

When you sell your capital assets for a price higher than the total amount they initially invested, the resulting earnings are referred to as capital gains.

3. Holding Period

The duration between the acquisition and liquidation of mutual fund units is crucial. According to India’s income tax regulations, an extended holding period results in a reduced tax liability. Consequently, the length of time you retain your investment significantly affects the applicable tax rate on your capital gains. A longer holding period translates to a lower tax obligation.

Now that you know the factors determining tax benefits on mutual funds let’s see how you can use mutual funds to achieve tax benefits.

1. Investment in Equity-linked Savings Scheme (ELSS)

Investing in ELSS is a savvy strategy for individuals looking to harness tax benefits while seeking long-term capital appreciation. ELSS funds are mutual funds designed to combine the advantages of tax savings with the potential for growth in the equity market. One of the primary attractions of ELSS is the tax deduction it offers under Section 80C of the Income Tax Act under the old tax regime. With ELSS you can get an exemption of up to Rs. 1.5 lakh from your taxable income, making ELSS an effective tool for reducing the overall tax burden.

2. Get the Benefit of Indexation

Indexation is a powerful tool that you can use to enhance tax benefits regarding mutual funds. The concept behind indexation is to account for the decrease in the real value of money over time due to inflation. By using an inflation index, such as the Cost Inflation Index (CII) published by the government, you can adjust your mutual fund's purchase cost when calculating capital gains.

This adjustment helps reflect the investment’s true economic cost, ensuring that the gains are not overestimated for tax purposes. Note that starting from April 1, 2023, debt funds no longer receive indexation benefits, and all gains become taxable at the slab rate. Nevertheless, investments in debt funds made before April 1, 2023, will still retain indexation benefits for long-term capital gains.

Long-term capital gains on balanced hybrid funds and mutual funds, which invest more than 35% but less than 65% in equities, get a tax benefit of 20% with indexation. The table below shows the taxation on capital gains on various types of mutual funds:

Type of Fund Short-term capital gains (STCG) Long-term capital gains (LTCG)
Equity funds and Hybrid equity-oriented funds
15% + cess + surcharge
Gains above Rs 1 lakh are tax free. Anything beyond that is taxed at 10% along with cess and surcharge
Debt funds and Hybrid debt-oriented funds
Taxed as per your tax slab
Taxed as per your tax slab

Summing it Up

Understanding the tax implications and making informed investment decisions can maximize your returns and minimize your tax liability. Consult with a certified financial advisor to tailor your investment strategy to your unique financial situation and goals.

FAQs on How to Invest in Mutual Funds for Tax Benefits

Yes, you can get a tax benefit of up to Rs 1.5 lakh on ELSS investment under section 80C of the Income Tax Act, 1961, under the old tax regime.

Initiating an SIP into an ELSS, the widely favored tax-saving investment under Section 80C of the Income Tax Act, 1961, allows every SIP installment to contribute towards tax deductions under Section 80C.

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