Tax Saving Mutual Funds: Time to cut your tax bill and create wealth too

Come December and the human resource departments in your offices call for investment proofs of your investments. Failing to submit the required documents may result in income tax deduction from your next month’s salary. More so, last-minute hushed up investments may not necessarily serve the purpose and sometimes end up thumping a liability on you. Hence, it makes sense to take an informed decision. Today, we will understand how tax saving mutual funds can help you reduce your tax outgo and build a large corpus.

What is a tax saving scheme?

Tax saving schemes, technically known as Equity Linked Saving Schemes (ELSS), invest at least 80% of a scheme’s money in equity and equity-related securities of companies. To put it simply, these schemes buy shares of companies and build diversified equity portfolios. Investments up to Rs1.5 lakh in an ELSS can help you enjoy tax deduction under section 80C of the Income Tax Act. This deduction is available along with contributions to Employee Provident Fund (EPF), Public Provident Fund (PPF), Sukanya Samriddhi Yojana, life insurance premium, tax saving bank fixed deposits and even home loan principal repayment.

These schemes come with a lock-in of three years, which is the lowest among competing tax saving investments.

How have they fared so far?

There are 38 tax saving schemes managing assets worth Rs 152,560 crore, as on 31 October, 2022. On the average, tax saving schemes generated 16.73% returns in the three years ended 18 November 2022. Compared to this, flexi-cap funds have given 15.77%. This means ELSS schemes have delivered good returns to investors. In the long term—say 10 years, ELSS schemes have given 14.9%.

Why investments in ELSS fetch good returns?

These schemes are open-ended equity schemes with a lock-in of three years. To put it simply, you can walk in any time and walk out subject to lock-in of three years from the date of allotment of units. Fund managers of these schemes usually build well diversified portfolios with shares of companies of all sizes – large, mid and small. As on 31 October 2022, on the average these schemes have allocated 72% money to large-cap stocks and the rest to mid-and-small-cap stocks.

These portfolios tend to do well over the long term and hence long-term investors tend to make sizeable money. There is no compulsion to sell units of ELSS after the end of lock-in period of three years. You can hold on to them as long as you want to and enjoy the benefits of compounding since the underlying portfolios have at least 80% allocation to stocks.

The lock-in period actually works in the favour of investors. Investors cannot sell her units in the lock-in period. This helps investors in dealing with volatile phases in the stock markets. Some experts also recommend first time investors to come through ELSS as these schemes help investors digest volatility which is the second nature of the stocks.

Going by past performance, ELSS emerges as a clear winner compared to all other tax saving investment options. Though past performance is encouraging, ELSS schemes are expected to deliver around 12% returns in the long term. This is a conservative estimate. At present, National Saving Certificate offers 6.8% and Public Provident Fund offers 7.1% returns. Tax Saving Bank Fixed Deposits pay around 6.5% to 7.2%. This reflects the attractiveness of investing in an ELSS for the long-term

How should you invest?

Though investing in a tax saving is a good idea, you should be measured in your approach. First ascertain how much money you want to invest. Account for your existing commitments that can fetch you a tax break. Once you come to know the amount, then you can pick a well-managed tax saving fund and invest in it. If you are pressed for time then you should make a lump sum investment. However, such quick moves sometimes invite timing risk – the probability of investing all your money at the market peak.

To avoid such risk and to overcome cash crunch caused by lump-sum investments, it is better to start a systematic investment plan at the beginning of the financial year. ELSS schemes such as Mirae Asset Tax Saver, Kotak Tax Saver can be considered for the same. If you are a bit aggressive, then consider IDFC Tax Advantage Fund.

In most cases, these are small investments in absolute terms. Hence, no need to diversify across ELSS. Stick to one or maximum two schemes and keep investing depending on your needs. Over a long period of time these investments can build a large enough corpus for you.