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The tax-saving trick of mutual funds!

Here's why mutual funds trump all other instruments when it comes to tax efficiency

About a month ago, I wrote a detailed column explaining the exact nature of the tax advantage that mutual fund investments offered over bank fixed deposits. The case I discussed was one where the goal was to earn a monthly income. In an example investment where the annual income received was Rs 80,000, the tax outgo for bank deposits was Rs 24,720, while for mutual funds it was Rs 1,831. It turns out that a lot of people who never invest in mutual funds don't really understand taxation on investments and were shocked at this. Even those who understand tax laws have not thought through the exact implications for specific types of investments.

The reason for mutual funds being so much more tax efficient is, of course, the fact that the returns are delivered to the investor's books as capital gains whereas in bank deposits, they are delivered as interest income. This makes a huge difference.

In general, some major advantages of investing in mutual funds come from these kind of transformations. Broadly, there are three ways through which investment can deliver gains. One is interest income, the second is capital gains and the third is dividends. For example, deposits of all kinds deliver only interest income. Bonds too deliver interest income but if they are traded on the markets they can yield capital gains. Equity delivers dividends as well as capital gains.

When you invest in stocks, the capital gains are generated in the stock markets, and depend on the stocks price movements as well as your acumen in buying and selling them. Dividends, on the other hand, are decided by the company's management, and in practice, most of the time, have only a small and transient effect on the stock price. In the background, both depends on the company's profitability but the mechanisms are different.

Mutual funds, just like stocks, can deliver gains as either capital gains or as dividends. However, there is an important difference. Funds invest in stocks or bonds out of the pooled money that investors give them. They earn capital gains, dividends and interest income. However, they are free to distribute the gains as capital gains or dividends, as they wish and as is convenient for their investors. Practically, all mutual funds have growth (capital gains) plans and dividend plans. The same underlying gains, regardless of the source, are distributed as either, and investors can choose whichever they want.

This has some good outcomes and some bad. The good part is that knowledgeable investors can fine-tune their tax strategies as per their needs. The above example is based precisely on such a transformation. The bad part is that investors who do not have a complete understanding of what is going on get misled by the use of the word 'dividend'. Mutual fund dividends are not dividends in the sense of corporate dividends. They are just your own money returned to you under the 'dividend' label. If you had chosen a growth option in the same fund, then the very same amount would have been available as capital gains.

However, many investors instinctively feel that a dividend is something extra and believe--unfortunately, are led to believe by fund salespersons--that a fund that pays more dividend is a better one. This is simply not true. A mutual fund dividend is simply a payout from your own money.

Even so, the facility of transforming one kind of gain into another is a great option that mutual funds have. Specially in debt funds, they enable a huge tax efficiency. Debt funds generate part of their gains from interest income. Through a mutual fund, these can be transformed into capital gains or dividend income.

The convenience and the savings can be considerable.