Mutual Funds by their very nature are not tax saving instruments but investment products that may offer tax concessions. But the question is whether these should be looked at as tax saving instruments?

Equity Linked Savings Schemes (ELSS) Are Strong Favorites

ELSS schemes give twice the benefit as compared with diversified equity schemes. They give you tax sops on investments and are also exempt from long term capital gains tax.

These are special equity funds, which have to invest at least 80% of their corpus in equity, and investments are locked in for a period of 3 years. Investments can get you benefits under Section 80 C i.e. investments of upto Rs 1 lakh in such schemes can be reduced from your gross income.

ELSS is the best example of an investment option that provides you a very simple way of investing in stock market and save taxes while doing so. Being equity oriented schemes, ELSS have the potential to provide better returns than most of the options under section 80C. Also, as per the current tax laws, an ELSS investor is not only entitled to earn tax free dividend but also the long term capital gains are not taxable.

But should an investor go the whole nine yards and put in the entire permissible amount of 1 lakh in ELSS? Probably not!

Section 80 C covers your principal on housing loan, PF, pension plan, life premiums, so only what is left after that can give you a benefit if invested in ELSS.

All Smiles From Equity Funds:

Apart from ELSS schemes, diversified equity schemes are a good investment considering that capital gains in equity funds below one year are taxed at a rate of 10% and over a year are tax-free. This option can be best exercised using a Growth Plan offered by mutual funds. The primary objective of a Growth Plan is to provide investors long-term growth of capital.

Dividend paid in Dividend Plans is tax free, and no distribution tax is deducted. However, every time we buy or sell equity shares a Securities Transaction Tax, STT, of 0.25% is paid and further when you redeem your investment, again STT is deducted from your redemption price.

So what strategy will help to reduce the burden of STT to the minimum possible extent?

Choose the dividend option, while it remains tax-free. Though both decisions are by and large tax-neutral, your STT will go down if your profits have already been taken out by you in the form of dividend

Debt Funds Can Benefit From Indexation

Debt funds have lost their sheen thanks to falling interest rates and paling tax sops when compared with equity schemes.

Any fund wherein the average holding in equity is 65% (as per Budget 2006) or below is treated as a debt fund. If you invest for less than 1 year in the growth option of a debt fund, you will have to pay Capital Gains Tax on your "profits" at the rate at which you pay income tax on your income. But, if you stay invested for over a year, you can either pay 10% tax on the profits or pay 20% after reducing the rate of inflation (indexation benefit). So if you are invested for three or four years, your tax may become much, much lower than 10%.

Nevertheless for the risk averse, there are ways to reduce the tax burden on returns.

Investors can also benefit from double indexation benefit (when you invest late in one financial year say on March 28, 2005, and redeem early in the next financial year say on April 2, 2006, you use the index of both Financial Year ending March 2006 and March 2007 to get this benefit for as little as 366 days) provided the two financial years' index adds up to more than 10%.

In the dividend option, dividend is tax free in your hands. But the dividend distribution tax deducted at source also comes out of your NAV. So you end up paying a tax of 10%. Further any increase in NAV over and above the dividend distributed, is taxed as in the case of the growth option.

Most debt fund investors who have a reasonable horizon to invest for at least one year or more, in any case and choose the growth option, since by and large this would prove most tax efficient for retail investors in the lower tax brackets