Learn more about tax-saving mutual funds

If you are a hard-working, hard-earning individual, chances are that you are going to have to invest some time in tax planning for the next financial year.

The question that is probably foremost in your mind is how to save as much as possible on the amount of tax you will have to shell out.

As you know, irrespective of the income, the maximum deductions that can be made from your taxable income are up to Rs 1 lakh (Rs 100,000).

While the Public Provident Fund and National Savings Certificates are the traditional way to go, you might want to consider investing in ELSS, or Equity Linked Saving Schemes.

Firstly, what are Equity-Linked Saving Schemes?

These are mutual funds that invest in the stock market and give the tax benefit under Section 80C of the Income Tax Act.

How this works is that the fund manager will invest in shares of various companies across various industries. So, in fact, it is a normal equity diversified fund. But there is the added tax benefit which a normal diversified equity fund will not have.

This sets it apart. And currently, if you invest in such funds, you get a rebate. This is the immediate plus of the ELSS mutual fund.

What makes ELSS a better option than other saving instruments?

The answer is really very simple. When you invest in ELSS mutual funds, you not only save the amount permissible by the government, you also stand to gain from it, because of the high rate of return.

There are, of course, many reasons why you should go the ELSS way.

The returns are really very good -- the year ending 2005 saw ELSS as the best performing in the mutual fund category, showing returns of nearly 60%. In fact, a number of funds have appreciated by more than 80% in their three-year period.

However, though in the past few years things have not been so good due to the economic downturn and recession effects, remember equities are long term investments that yield better in the long run (a span of 10-12 years).

These funds have a lock-in period of three years, which prevents you from unnecessary withdrawals and spending and helps earn a return over time. However, remember to stay invested for longer periods of time to the tune of 10-12 years to reap the best of returns.

Also, the lock in gives fund managers the freedom to take sector and stock bets, which they are not able to do in the regular equity schemes.

The dividends you earn will be tax free.

When you sell the units of these funds, you can avail of the long-term capital gain for which there is no tax. If you sell after one year, you pay no tax.

Points to consider before you invest

Unlike the Public Provident Fund or the National Savings Certificate, the returns here are not guaranteed. While there is a chance at earning handsome returns, the likelihood of incurring losses is also high.

Also, unlike PPF and NSC where investing at one go does not have any impact on the investment, lump-sum investing in an equity fund could be dangerous.

It is always wise to have some amount of equity in your portfolio. If you are not too sure about directly getting into the stock market, a mutual fund is your best bet.

Remember that the younger you are, the greater the amounts you can think of investing in these schemes. As per the mandate, a minimum of 90% of investments by ELSS should be in equities at all times. But it is always wise to have some amount of equity in your portfolio.

And if you are not too sure about directly getting into the stock market, a mutual fund is your best bet. Decide how much you want to invest in an ELSS and start investing a fixed amount right away every month, and watch your nest egg grow.