We keep hearing a lot about how mutual funds have helped create wealth for investors. However, it is also important to know that mutual funds not only help you increase your wealth but are also tax-efficient investment avenues. Tax efficiency does not mean just helping one pay less income tax but also to avoid or reduce tax liability on returns generated on your investment.

Let’s know more about the tax implications of mutual funds and explore ways in which mutual funds can help lower your tax liability.

ELSS funds help you earn money and save tax

Equity-linked savings schemes (ELSS) are a type of diversified equity fund that qualify for tax exemption under the Income Tax Act and offer the twin-advantage of capital appreciation and tax benefits. These popular plans offer a simple way to get tax benefits and at the same time give an opportunity to gain from the equity markets. ELSS comes with a three-year lock-in. In addition, for firsttime investors in equity funds covered under the Rajiv Gandhi Equity Savings Scheme, there is also an additional one-time tax deduction available.

Taxation of equity and non equity funds

Tax implications of mutual funds vary depending on the category of fund you invest in. For tax implication purpose, based on the equity exposure of a scheme, mutual funds are classified as equity-oriented schemes and others. You must note that irrespective of the fund category, the dividend that you receive is exempt from tax. However, the scheme does pay out the dividend distribution tax before paying a dividend

Debt / Liquid Mutual Fund schemes are more tax efficient than Bank FDs

Bank deposits are considered the most popular investment avenue to park money and also one of the safest with guaranteed interest income. But for individuals who belong to high income brackets, debt and liquid oriented funds can be a good alternative because of the tax-efficiency that these funds offer. The interest earned on a bank deposit is added to an individual’s income and taxed at the applicable income tax rate. In comparison, debt and liquid schemes offer tax advantages as they have a lower tax rate.

Here, in the dividend option, the fund house pays a dividend distribution tax (DDT). An individual under the highest tax bracket will pay tax at 30.9% on the interest he earns in a bank savings account. Similarly, in growth option, returns from liquid and debt funds would attract longterm capital gains if redeemed after a year (10% without indexation and 20% with indexation plus cess).

Thus, when we look at all these options, debt/liquid mutual funds appear to be better options if you belong to the highest tax bracket where tax eats away almost 30% of your returns. Remember, taxes follow you wherever you make money. But there are smart ways to deal with it.