What are tax saving mutual funds and how can it help create long term wealth

Tax payers can claim deductions of up to Rs 1.5 lakhs every year from their gross taxable income by investing in various schemes allowed in Section 80C of Income Tax Act 1961. Tax savings investment options like Public Provident Funds (PPF), National Savings Certificates (NSC), tax saver term deposits (offered by both banks and post offices), Senior Citizen Savings Schemes (SCSS) etc. are risk free investments. Tax Savings Mutual Funds or Mutual Fund Equity Linked Savings Schemes (ELSS)are however, subject to market risks.

Also read – what is Equity Linked Saving Scheme (ELSS) of Mutual Funds

While the risk free tax saving investments provide safety of capital, the returns generated by them on a post tax basis may not be adequate to meet various long term financial goals. Though tax saving mutual funds is subject to market risks, they are one of the best tax saving investment options for investors with a long investment horizon. Tax Savings Mutual Funds or ELSS funds are diversified equity mutual fund schemes, which invest in a diversified portfolio of stocks across different sectors for generating capital appreciation over a sufficiently long investment horizon.

Historical data shows that, equity is the best performing asset class over a long investment period as it has outperformed asset classes like gold and fixed income investments. In the last 20 years, the BSE Sensex has given 11.8% annualized returns, while gold has given 9.2% and fixed deposits have given only 7.2% annualized returns respectively.

Good performing Tax Savings Mutual Funds have consistently beaten the market benchmark indices and given superior returns. The wealth creation potential of Tax Savings Mutual Funds or Equity Linked Savings Schemes is substantial. If you invest Rs 1 lakh every year in a Tax Savings Mutual Fund for the purpose of tax saving, over a 10 year period, assuming 15% annualized returns, you can accumulate a corpus of more than Rs 20 lakhs, in addition to saving up to Rs 3 lakhs in taxes (assuming tax slab to be 20%) over the 10 year tenure.

Over a 15 year period you can accumulate a corpus of nearly Rs 48 lakhs by investing Rs 1 lakh in ELSS every year for tax saving (assuming a 15% annualized rate of return), in addition to saving up to Rs 4.5 lakhs in taxes over the 15 year tenure. Over a 20 year period you can accumulate a corpus of over Rs 1 Crores by investing Rs 1 lakh in Tax Savings Mutual Funds every year (assuming a 15% annualized rate of return), in addition to saving up to Rs 4.5 lakhs in taxes over the 15 year tenure (Tax slab assumptions at 20%)

See the top performing tax saver mutual funds in India

Investors often ignore the impact of taxes on wealth creation. For example, a fixed deposit scheme may give investors 9% interest per annum, but if the interest income is fully taxable, then the effective return for the investor is only around 6.3% (for investors in the highest tax bracket). Interest paid by most risk-free tax saving schemes eligible under Section 80C are taxed as per the income tax rate of the investor. On a post tax basis, the inflation adjusted return of risk free investments is often very low, close to zero.

Tax Savings Mutual Funds or ELSS Schemes, on the other hand, are among the most tax efficient investments. Profits (long term capital gains) made are tax free along with the dividends paid by Tax Savings Mutual Funds are also tax free. The tax efficiency of these funds makes it as one of the best investment options for wealth creation while saving taxes too.

Read what are mutual fund tax benefits

Making tax savings investments often means locking up your capital for a long period of time. Lack of liquidity in investments can reduce the flexibility of your financial plan. Tax Savings Mutual Fund offers higher liquidity compared to all Section 80C investment options. PPF have tenures of 15 years with limited liquidity in the interim. Traditional life insurance policies also have long maturity tenures from 5 years to as long 30-35 years and surrender charges may apply if you want to surrender the policy before maturity. Unit linked life insurance policies (ULIPs) usually have lock-in period of 5 years; if you stop paying premiums before the 5 year period, surrender charges will apply and you will lose your insurance cover. NSC and tax saver FDs (banks or post office) also have 5 year tenures. Therefore, the Tax Savings Mutual Fund is the most liquid tax saving investments as they have a lock-in period of just 3 years and this makes them the most flexible tax saving investment schemes which also offers the potential of highest return in the long run.