Besides the obvious PF contribution, Tax saving mutual funds
and Tax saving fixed deposits are the most popular and sought after source to
claim deductions under section 80c of the Income Tax act.
Even though both can be used to claim deductions, there are several
differences between the two.
Fixed Deposits
Tax saving fixed deposits are like your regular fixed
deposits except for they come with a lock in period of 5 years and be claimed
for tax deductions.
Regular tax saving fixed deposits cannot be claimed for tax
deductions.
The interest rate will vary from bank to bank.
KYC is required is to open your FD with a new bank, not
required if you open your FD with your current bank.
Not Inflation protected
A tax saving fixed deposit is not inflation protected and
it is the biggest drawback of a tax saving fixed deposit.
If the rate of your fixed deposit is 5% and over the period
of the lock in period, say the average inflation is 6% then in such a case
technically you did not gain 5% on your fixed deposit but in fact lost 1%.
Therefore in reality you don’t gain any real returns.
Inflation is a reality for all developing economies.
This is the reality for all fixed deposit schemes and not
just for a tax saving fixed deposit.
This is precisely why for long term planning, investments
that can outperform inflation are recommended.
Capital protected
The capital of your tax saving fixed deposit is protected up
to 5 lakh by the Deposit Insurance and Credit Guarantee Scheme.
This means no matter what, even under the most unforeseen of
circumstances your capital amount is assured.
This of course does not apply to the capital amount beyond 5
lakhs.
Additional reading: Click Here to read why you should review your mutual fund portfolio yearly
Liquidity
A tax saving fixed deposit cannot be withdrawn before the
lock in period of 5 years under any circumstances.
Loan against the deposit is also not permitted.
Taxation
The interest gained on a tax saving fixed deposit is not tax
free.
The interest from a tax saving fixed deposit is added to the
total income of the individual.
The tax rate will therefore depend on the tax slab of the
individual.
In reality therefore a tax saving fixed deposit is not at
all favourable for someone who falls under the 30% tax bracket since the total
interest gained after taxation is extremely low.
ELSS Mutual Funds
Equity Linked Savings Scheme, better known as ELSS
Funds or Tax Saving Mutual Funds allow an individual or HUF to invest in a
diversified equity mutual fund to claim a deduction up to Rs. 1.5 Lakhs under
Section 80C of the Income Tax Act 1961.
These funds allow an investor to claim dual benefits of tax saving along with
availing equity growth.
What
are tax saving mutual funds?
Elss means tax saving mutual funds that allow tax deductions
under 80c of the Income tax act.
Tax saving mutual funds have a short lock in period of 3 years as opposed to other tax saving instruments with lock in period ranging from 5 to 7 to 10 years.
Elss mutual funds is your best option since it provides both
tax saving as well as capital appreciation.
To get the true benefits of elss funds, they should be first
looked at as an investment and a tax-saving option.
Additional reading: Click Here to read about the various types of equity mutual funds
How
does tax saver mutual fund work?
A tax saving mutual fund is similar to a flexi cap mutual
fund in the sense that it does not have any restriction with regards to caps.
It is free to invest wherever it wishes to as long as 80% of
the portfolio is invested in equities at all times.
It comes with a lock in period of 3 years, for sip each
instalment would need to complete 3 years before you can withdraw it.
Since it comes with a lock in period of 3 years, fund
managers have a sense of stability in terms of AUM which provides them with
more room to take concentrated bets.
Every tax fund is managed differently from the other since
there are no set rules as such.
Therefore, relying merely on past returns can be very
harmful for your portfolio, instead a better understanding of the philosophy of
the fund and your needs is what is required.
Taxation
Elss funds are taxed like any other equity mutual fund.
No tax is imposed for profits under Rs 1 lakh.
For profits exceeding Rs 1 lakh, 10% Long Term Capital Gains
tax (LTCG) is imposed.
Short Term Capital Gains tax (STCG) cannot be imposed on tax
saving mutual funds since they have a lock in period of 3 years so by default,
they stay invested for more than a year.
Liquidity
You can withdraw your elss funds only after they have
completed 3 years.
For SIP investments in tax saving funds, each sip instalment
is considered as a fresh purchase and therefore each SIP instalment would need
to complete 3 years.
No partial redemptions or transfers are allowed before the
completion of 3 years.
Lowest lock in period
Elss funds have the lowest lock in period among all the tax
saving instruments
|
Instrument |
Lock in period |
|
Elss funds |
3 years |
|
Public Provident
Fund |
15 years |
|
National Savings
Certificate |
6 years |
|
Bank Fixed Deposits |
5 years |
A fixed deposit makes sense in the short term for emergency
purposes since capital protection takes precedence over returns where emergency
is concerned.
A tax saving fixed deposit on the other hand though makes
little to no sense at all considering the real returns and the higher lock in
period of 5 years.
In the long run an elss fund scores over a tax saving fixed
deposit in various departments from beating inflation, higher returns and a
shorter lock in period.
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