Mutual funds ‘high’ way offers options galore

Mutual funds are one of the most effective wealth-building mechanisms. Note that I call it a mechanism and not an investment instrument. Why is that? Well, while most investors tend to perceive a mutual fund as an alternative investment option, in reality this is not true. Mutual funds are actually a vehicle for the funds to reach the eventual desired destination. Let me explain.

If you wish to invest in bonds, you can do it through an income fund. Or is it government securities that you would rather invest in? Again, you can invest in government securities by buying a gilt fund, and if gold is where you would like to invest, you can invest in a gold fund. For those interested in equity shares, there is the option of the equity-oriented fund. And then, there are combinations. If you would want a bulk of your money be invested in bonds with a sprinkling in equity, then a monthly income plans (MIP) fund is the answer for you. On the other hand, if the debt-equity mix needs to be tilted towards equity, one should opt for a balanced fund. So you see, a mutual fund, in effect, is not the end but rather a means for the end.

Now, as mentioned above, mutual funds come in various flavours - open-ended, close-ended, sectoral funds, balanced funds, MIPs, fixed maturity plans (FMP), gilt funds, income funds and so on. However, the Income Tax Act recognises only two types of funds — equity funds and non-equity funds. Period. Tax benefits differ for each one. An equity fund, to put it simply, means a fund that invests more than 65% of the money in equity shares. The Income Tax Act has bestowed enormous tax benefits on such funds. Let’s see what these are:

For an equity fund:
- Long-term capital gains are tax-free
- Short-term capital gains are taxed at only 15%
- Dividend is not subject to dividend distribution tax.

For a non-equity fund:

- Long-term capital gains are taxed @20% with indexation or 10% without indexation
- Short-term capital gains are to be added to the other income of the investor and taxed at applicable slab rates
- Dividend is subject to a 12.5% distribution tax.
- There is no STT applicable Budget 2006 does away with the differentiation between open-ended and close-ended funds

Close-ended funds are those that have a fixed maturity date.

Open-ended funds are on tap — you can buy and sell them anytime - there is no maturity date as such. Prior to the Budget in 2006, only open-ended equity funds were exempted from dividend distribution tax. Close-ended funds, even if investing 100% in equity had to bear this tax. This anomaly has since been rectified.
Another variant of an equity fund

Then, there are Equity Linked Savings Schemes (ELSS) funds. ELSS, to put it simply, are equity funds that offer a tax benefit over and above those mentioned above. Any investment in an ELSS fund offers Sec 80C deduction that is, the amount invested is deductible from your taxable income. However, Sec 80C has a cap of Rs1 lakh, so only an investment up to Rs1 lakh gets the tax benefit. The table illustrates the same with a simple example.

Now, tax saving pre-supposes a lock-in. In other words, without a lock-in period, Sec 80C benefit is just not available. All instruments under Sec 80C have a lock-in and so does ELSS. It is one of the instruments where money is blocked for just three years.

Also, ELSS funds in general have been found to outperform their equity diversified counterparts. This happens essentially as the fund manager has the money at his disposal for a long-term, without having to cater to everyday redemptions. Therefore, regardless of the tax benefit, even investing over Rs1 lakh may be an idea to consider.

Which option should you choose?
Here I don’t mean investment options, but options within the investment. As most investors would know, mutual funds come

with essentially three options:
- Dividend
- Dividend Reinvestment
- Growth

The dividend option is pretty straightforward, in that, as dividend is tax-free, those investors who prefer some kind of regular cash flow should opt for the same. This also means automatic periodic profit-booking, which is good in a rising market.

With the current tax structure, there is no difference between the dividend reinvestment and growth options. However, say there is a distribution tax imposed in the future. Then, it is much better to choose the growth option than suffer the distribution tax. However, envisage a scenario where there is a long-term capital gains tax imposed. In such a case, the dividend reinvestment option proves to be fiscally more beneficial. Therefore, options should be chosen as per cash flow requirements and tax incidence, as is currently applicable.

To sum it up
Mutual Funds provide the most optimum mix of return, risk, liquidity and tax efficiency. Of course, provided they are used well. If you had a personal portfolio manager, he would have told you that equities have known to earn the highest return in any asset class over the long-term, the operative words being long-term.Well, your mutual fund is your personal portfolio manager. Allow him to do his thing. Frequently getting in and out only hampers the journey… and when it comes to successful investing, it is the journey that is more enjoyable than the final destination.

The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com