Tax Planning Through Mutual Funds

[Tax Planning Series]

Session 4: Tax Planning through Mutual Funds

We are glad to have you with us for our 4th Session on Tax Planning and that is...

Tax Planning Through Mutual Funds

In the last few sessions of money simplified we took you through tax saving investment options under Section 80C of the Income-tax Act, 1961 and how aggressive as well as conservative investors can go about tax planning. Moving forward, in this session of the tax planning series, we’ll elucidate how you could undertake tax planning with mutual funds.

As you may know mutual funds -
  • Offer diversification across asset classes;

  • Offer variety of plans & options;

  • Are professionally managed and well regulated;

  • Offer low minimum investment, convenience of SIPs (i.e. Systematic Investment Plans) and economies of scale

  • Offer Tax Efficiencies

  • Offer high liquidity (for open ended funds) and

  • Offer the potential to earn higher inflation adjusted returns

So, if selected wisely they potentially reward you well for the risk taken. Moreover, tax planning is also possible through mutual funds.

Here are types of mutual fund schemes you can consider for tax planning...

Mutual fund schemes for tax planning

So, if you match traits of a conservative investor or one who is averse to taking risk, tax saving investment instruments offering assured returns would be a suitable choice for tax planning.

Let’s discuss the tax saving investment instruments you may consider in this category...

  • Equity Linked Saving Schemes (ELSS)

  • These are also known as tax saving mutual fund schemes. Distinguishing features about them are:

  • Come with a lock-in period (of 3 years)

  • Minimum investment of Rs 500 can be made with no upper limit

  • Both lump sum and SIP mode available for investing (For SIP mode, each unit will need to complete the lock-in period)

  • Withdrawals are allowed post lock-in; and

  • Dividends and capital gains are tax-free

  • The amount invested in ELSS qualifies for deduction u/s. 80C (of Income Tax Act, 1961) upto a sum of Rs 1.50 lakh p.a.

  • If you have a higher risk appetite (i.e. you’re an aggressive investor), ELSS funds may be a predominant portion of your tax saving portfolio. But don’t invest in ELSS blindly or just by past performance; because it may or may not be sustained in the future. Look at the risk taken to generate the returns, portfolio turnover, expense ratio and other portfolio characteristics. Also while selecting, you may give importance to those which have completed at least 5 years of track record and are from mutual fund houses that follow strong investment policies and processes.

    Also while you consider ELSS for tax planning don’t approach it as a 3-year product because of the lock-in period; but more as a product to achieve long-term goals which are generally more than 5 years away.

  • Rajiv Gandhi Equity Savings Scheme (RGESS)

  • This scheme was introduced in the Finance Act, 2012, under Section 80CCG that provides for deduction for investment in RGESS.

    • But only new retail investors who comply with the conditions of the scheme and whose gross total income for the financial year in which the investment is made under RGESS is less than Rs 12 lakh can avail a deduction by investing in RGESS. New retail investor interalia shall mean any resident Individual who has not opened a demat account or who has opened a demat account but has not made any transactions in the equity segment or the derivative segment

    • The maximum investment permissible for claiming tax deduction under RGESS is Rs 50,000

    • As an investor you would get a 50% deduction of the amount invested from the taxable income for that year u/s 80CCG. The benefit is in addition to deduction available u/s Sec 80C

    • First time equity investors can invest into units of mutual funds and ETFs under RGESS.

    • RGESS also includes eligible listed equity or Follow on Public offer of such listed equity.

    • First time equity investors can invest into units of mutual funds and ETFs under RGESS.

    • The total lock-in period for investments under the RGESS would be divided into 'fixed lock-in period‘ and 'flexible lock-in period’. The initial period of lock in shall be known as Fixed Lock-in Period, which shall commence from the date of purchase of such securities in the relevant financial year and end on the 31st day of March of the year immediately following the relevant financial year. A new retail investor shall not be permitted to sell, pledge or hypothecate any eligible security during this fixed lock-in period. The period of two years beginning immediately after the end of the fixed lock-in period shall be called the flexible lock-in period. Upon completion of the fixed lock-in period, new retail investors would be allowed to trade in the eligible securities. Investors would, however, be required to maintain their level of investment during the next two years (i.e. the flexible lock-in period) at the amount for which they have claimed income tax benefit or at the value of the portfolio before initiating a sale transaction, whichever is less, for at least 270 days in each of these 2 years. Such investment value shall exclude the value of investment which is under the fixed lock-in period.

    If you have a high risk appetite (i.e. you’re an aggressive investor) but new to investing in equity, you may consider RGESS for your tax saving portfolio.

  • Pension Funds

  • Those who are moderately conservative can consider pension funds.

    • Debt oriented Pension funds typically allocate a predominant portion of their assets in debt and the rest in equity.

    • They have a higher potential for wealth creation over the long run than assured returns products owing to the equity component.

    • However, pension funds do carry some element of risk vis-à-vis assured returns products owing to their market linked nature.

    • The amount invested in pension funds qualifies for a deduction under Section 80C (of Income Tax Act, 1961) upto a sum of Rs 1.50 lakh p.a.

    • All debt-oriented pension funds are subject to long term capital gains tax (LTCG) (post indexation benefits)

    Pension funds can be an effective tool to plan one’s retirement. At the vesting age i.e. after you retire, you may choose to withdraw fixed amounts at a regular frequency through Systematic Withdrawal Plans (SWPs) to meet your retirement cash flow needs.

    Learning by example:
    Computation of Tax Liability of new retail investor (2016-17)
    Gross Total Income (a) Tax Rate 1,100,000
    Investments done in FY2016-17
    RGESS 50,000
    ELSS 100,000
    Pension Funds 25,000
    Eligible for deduction u/s. 80C (b)
    (ELSS & Pension Funds)
    Eligible for deduction u/s. 80CCG (c) (50% of RGESS investment) 25,000
    Net Taxable Income (in Rs) (a) – (b) – (c). 950,000
    Upto 2,50,000 Nil
    Rs 2,50,001 to Rs 500,000 10% 25,000
    Rs 500,001 to Rs 10,00,000 20% 90,000
    Rs 10,00,001 & above 30% -
    Tax payable (in Rs) 115,000
    Education Cess 3% 3,450
    Total Tax Liability (in Rs) 118,450
    This table is for illustration purpose only
    (Source: PersonalFN Research)

    Now let’s say you are a new retail investor and your Gross Total Income is Rs11.00 lakh and you have invested a sum of Rs 1,00,000 in ELSS, Rs 50,000 RGESS and Rs 25,000 pension funds. For deduction under chapter VIA of the Income Tax Act, you can avail Rs 1,25,000 deduction under Section 80C for investments in ELSS and pension funds (put together), while for RGESS: 50% of the amount invested i.e. Rs 25,000 under Section 80CCG. Therefore the total deduction you can avail will be Rs 1,50,000.

    This will help you reduce your Net Taxable Income (or NTI) to Rs 9.50 lakh and so will the tax liability to Rs 1.18 lakh as per this table.

    Other aspects of tax planning through mutual funds...

    • Besides holding ELSS, RGESS and pension funds, one should be cognizant of the holding period while holding other mutual fund schemes.

    • Holding period has impact on Short Term Capital Gains (STCG) tax and Long Term Capital Gains (LTCG) tax.

    • Having said that, if the exit from a mutual fund scheme becomes necessary owing to consistent underperformance or any other negative reason, you may give priority to redemption to cut further losses rather than calculating tax impact.

    We will discuss the tax implications of investing in mutual funds in our ensuing lecture.

    Points to Remember...

    • While you endeavour to achieve your long-term financial goals, mutual funds can also help you in tax planning

    • But select your mutual fund schemes prudently

    • While ELSS has a lock-in period of 3 years don’t approach it as a 3-year product but more as a product to achieve long-term goals

    • RGESS is available only to new retail investors whose gross total income in a financial year is less than Rs 12 lakh

    • Maximum investment permissible for claiming deduction under RGESS is Rs 50,000. You can get a 50% deduction u/s. 80CCG of the amount invested

    • ELSS and RGESS are suitable for investors with a higher risk appetite or those classified as aggressive investors

    • Debt oriented Pension funds are suitable for moderately conservative investors. Nevertheless they carry some risk as a predominant portion of their assets are invested in debt and the rest in equity.

    • Pension funds can be an effective tool to plan one’s retirement

    • Be cognizant of the holding period while investing in mutual funds to avoid tax implications

    • If the exit from a mutual fund scheme becomes necessary owing to consistent underperformance or any other negative reason, priority may be given to redemption to cut further losses rather than calculating tax impact.

    So, complement tax planning and investment planning

    [This video transcript is dated April 29, 2016.]

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