Be it making money or saving tax, mutual funds can help you achieve both. Certain funds are specially designed to save tax like equity-linked savings scheme (ELSS) mutual funds. Investing in ELSS can be used for a deduction of up to ₹1.5 lakh under section 80C of the Income-tax Act, 1961.
ELSS offers one of the smallest lock-in periods among tax saving schemes which is three years. An individual cannot withdraw from the ELSS fund for this period. Once it is complete you can decide to continue investing or withdraw depending on your investment needs. Analysts usually advise investing in ELSS on a long-term basis which can give you better returns.
Since these are equity mutual funds it comes with higher risk as compared to other tax-saving schemes like PPF or fixed deposit.
Also, the return on your ELSS fund is directly proportional to the stock market performance. It is not fixed like in FDs or PPF.
How to invest?
You can invest in ELSS funds through systematic investment plans (SIP) as well as in a lump sum. If investing through the SIP route, you can start with as low as ₹500 per month but there is no upper limit. In case of a lump sum, ₹1.5 lakh is the maximum you can invest to get a tax break under section 80C in one financial year.
Types of ELSS?
While investing in ELSS mutual funds, you get three options for the type of investment you want: (i) Growth (ii) Dividend and (iii) Dividend Reinvestment.
In the case of the growth option, dividends are not paid to the investor and the total gain or loss is realized at the time of redemption.
Under the dividend option, you can choose to get dividends on a quarterly or yearly basis as decided by the fund house. However, one must note that these dividends are taxable.
The third option is dividend reinvestment, in this, the dividend paid by the fund houses are reinvested in the ELSS fund but once this enters back into your ELSS fund, it will be subjected to the same lock-in period as the whole fund.
Taxation
One must note that gains from ELSS funds will be subjected to long-term capital gains tax. Since ELSS has a mandatory lock-in period of 3 years, it won't be eligible for short-term gain tax which is for withdrawing from MFs in less than a year. Long-term capital gains tax is applied on equity mutual fund investments of above Rs. 1 lakh. These are subjected to 10 percent tax deductions without indexation benefits. LTCG below investment of ₹1 lakh is tax-free.
Hence, investing in ELSS funds may prove beneficial for you from a tax-saving perspective and also gather good returns in the long run. It is also a good tool for diversification since other MFs or investment in direct equity does not help save tax.