I want to invest some amount in mutual funds (MFs) for 3 years but with a minimum lock-in period. I also want tax benefits. Please suggest some MFs and systematic investment plans (SIPs) for the same. I am planning to invest in ICICI Prudential Focused Bluechip Fund.
— Sachin Nambiar
The two concepts of tax benefits and lock-periods for MFs should be understood separately and clearly. When it comes to tax benefits, there are two kinds of benefits to consider: one is tax deduction, wherein the money invested can be deducted from the taxable income, and other is the tax treatment (or exemption), wherein the profits made from the investment are either not taxed or taxed at a beneficial rate.
While all MFs offer the latter—an advantageous tax treatment—only those equity MFs that are tagged as equity-linked savings schemes (ELSS) provide the benefit of tax deduction to investors. For example, ICICI Prudential offers a tax-saving fund called ICICI Prudential Long Term Equity Fund.
Remember, only investments made in ELSS funds are really locked—they cannot be redeemed until the lock-in period is over. These investments are locked for 3 years from the date of unit allocation. Investments in other MFs are not locked, but might be subject to exit loads—a kind of penalty at the time of withdrawal, if the withdrawal happens within the stipulated period of time.
The scheme you are considering—the ICICI Prudential Focused Bluechip Fund—is a good scheme but it is not a tax-saving scheme. As far as the method of investing goes, it is always prudent to use SIP for investing in equity MFs such as these.
I have been hearing a lot about short-term liquid funds nowadays. I invest via SIPs for tax purposes but keep the money needed for short-term in recurring deposits. How safe is it to invest it in short-term liquid funds?
—Rajesh Pratap Singh
Most people enter into MF investing through the tax-saving funds route. However, as they look around after they are in, they discover a world of other options. There are many options available in the debt market that provide competitive investment options with considerably lesser risk profile. In liquid funds, you have identified the least risky of these types of funds, which invest in short-term bond instruments. These funds are ideal for keeping money that would be needed in a short period of time. These funds are flexible and always provide an exit option to investors. Potentially, they could also deliver higher returns than the short-term deposit products. Whenever you would like to get a part or whole of your money back, you can place a redemption request and the money will come to your bank account in a single business day. Factors such as low risk, potential for higher returns, and the quick availability of money make these funds an ideal choice for parking money for a short duration.
I am told that debt funds can deliver higher returns than fixed deposits (FDs). Is this correct?
Yes, debt funds do hold potential to generate higher returns than FDs on a post-tax basis. Depending on the category of fund chosen, debt funds invest in different instruments such as certificates of deposits, commercial papers and gilts. Some of them invest in higher-accrual (interest) instruments, while others try to make the best of interest-rate movements. These two tactics, along with the flexibility to sell some of the instruments when the price of debt instruments (bonds) goes up, help debt funds to generate superior returns. This is especially the case with long-term debt funds such as income funds and dynamic bond funds. Besides, debt funds receive capital gains indexation benefit when held for over 3 years. This is not available with fixed deposits. A combination of these two factors enable a debt fund to potentially beat the FDs in terms of post-tax returns. But with MFs, returns are not guaranteed, as there are with the fixed deposits.
Will investments in debt mutual funds attract long-term capital gains tax?
Investments in debt mutual funds attract long-term capital gains tax. For such funds, long-term is defined as a holding period that exceeds 3 years. So, if a debt mutual fund is held for longer than 3 years, it will attract long-term capital gains tax. If held for a period shorter than 3 years, the gains will taxed at the investor’s slab rate.
The rate of tax on such long-term holdings is 20% of the gains (23.072% after surcharge and cess), after the purchase price is adjusted for indexation. So, effectively, if the holding period were a period of high inflation, then the taxation would be minimised significantly as the indexation adjustment will increase the cost of purchase, thereby minimising the gains.
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