Tax Benefits of Mutual Funds: How to Save More

21 Nov 2024

Investing in mutual funds is not just a great way to grow your wealth—it’s also an excellent tool for tax planning. Whether you’re a seasoned investor or just starting out, understanding the tax benefits of mutual funds can help you save more and optimize your returns. In this blog, we’ll explore the tax advantages of mutual funds, how they work, and how you can make the most of them.

Why Tax Planning with Mutual Funds?

Taxes can eat into your investment returns, but mutual funds offer several tax-saving opportunities under the Income Tax Act, 1961. By leveraging these benefits, you can reduce your tax liability and increase your net returns.

Tax Benefits of Mutual Funds

1. Equity-Linked Savings Scheme (ELSS)

ELSS is one of the most popular tax-saving mutual funds, offering dual benefits of wealth creation and tax savings.

Tax Deduction: Investments in ELSS are eligible for a deduction of up to ₹1.5 lakhs under Section 80C.
Lock-in Period: 3 years (shortest among Section 80C options).
Returns: Historically, ELSS has delivered higher returns compared to other tax-saving instruments like PPF or FDs.

Example:
If you invest ₹1.5 lakhs in ELSS, you can save up to ₹46,800 in taxes (assuming a 31.2% tax slab).

2. Long-Term Capital Gains (LTCG) Tax on Equity Funds

Equity mutual funds held for more than 1 year qualify for Long-Term Capital Gains (LTCG) tax benefits.

Tax Rate: 12.5% on gains exceeding ₹1.25 lakh per financial year.
Indexation Benefit: Not applicable for equity funds.

Example:
If you earn ₹2 lakhs as LTCG from equity funds in a year, only ₹75 thousands will be taxed at 12.5%, i.e., ₹9375.

3. Short-Term Capital Gains (STCG) Tax on Equity Funds

Equity mutual funds held for less than 1 year are subject to Short-Term Capital Gains (STCG) tax.

Tax Rate: 20% on gains.

4. Tax Benefits of Debt Funds

Debt mutual funds held for more than 3 years qualify for Long-Term Capital Gains (LTCG) tax with indexation benefits.

Tax Rate: 20% after indexation.
Indexation Benefit: Adjusts the purchase price for inflation, reducing taxable gains.

Example:
If you invest ₹1 lakh in a debt fund and redeem it after 3 years for ₹1.5 lakhs, the indexed cost (adjusted for inflation) might be ₹1.2 lakhs. Your taxable gain would be ₹30,000, taxed at 20%, i.e., ₹6,000.

5. Dividend Distribution Tax (DDT) Removal

As of FY 2020-21, Dividend Distribution Tax (DDT) has been removed. Dividends from mutual funds are now taxed at the investor’s income tax slab rate.

How to Maximize Tax Savings with Mutual Funds

Invest in ELSS for Section 80C Benefits:
- Use ELSS to save up to ₹1.5 lakhs in taxes while earning market-linked returns.
Hold Equity Funds for Long-Term:
- Avoid STCG tax by holding equity funds for more than 1 year and benefit from LTCG tax rates.
Use Debt Funds for Long-Term Goals:
- Hold debt funds for more than 3 years to benefit from indexation and lower LTCG tax rates.
Opt for Growth Option Over Dividend:
- Growth options reinvest profits, allowing you to benefit from compounding and defer taxes until redemption.
Plan Your Redemptions:
- Spread out redemptions to keep LTCG below ₹1.25 lakh per year and avoid taxes.

Tax Implications of SIP, STP, and SWP

SIP (Systematic Investment Plan):
- Each SIP installment is treated as a separate investment for tax purposes.
- LTCG applies if units are held for more than 1 year (equity funds) or 3 years (debt funds).
STP (Systematic Transfer Plan):
- Transfers from one fund to another are treated as redemptions and may attract capital gains tax.
SWP (Systematic Withdrawal Plan):
- Each withdrawal is treated as a redemption and taxed based on the holding period and fund type.

Example

Scenario:

An investor in the 31.2% tax slab invests ₹1.5 lakhs in ELSS and earns ₹2.5 lakhs as LTCG from equity funds in a year.

Tax Savings:

ELSS: Saves ₹46,800 under Section 80C.
LTCG: Pays 12.5% tax on ₹1.25 lakh (₹2.5 lakhs – ₹1.25 lakhs exemption), i.e., ₹15,625.

Net Benefit:
The investor saves ₹31,175 in taxes while earning market-linked returns.

Conclusion

Mutual funds are not just a tool for wealth creation—they’re also a powerful way to save on taxes. By understanding the tax benefits of mutual funds and planning your investments wisely, you can maximize your savings and achieve your financial goals faster.

At Adorn Solutions, we’re here to help you make informed investment decisions and optimize your tax savings. Whether you’re looking to invest in ELSS, equity funds, or debt funds, our experts will guide you every step of the way.

Ready to start your tax-saving journey? Contact us today!