Tax saving is an important part of an individual’s financial planning. If you wisely plan your taxes, you can end up saving a good amount of money from your hard-earned annual income. In this article, we are going to discuss how one can save taxes by investing in mutual funds.
What is Mutual Fund?
A mutual fund is an investment that is created by pooling money from different investors on the purchase of bonds, stocks and other securities. These funds are managed by official money managers who allocate these funds to produce capital gains. A mutual fund has a portfolio that explains its objectives, categories and type of returns. There is an annual fee associated with a mutual fund also known as its expense ratio.
In other words, a tax saving mutual fund is a pool of money collected from various investors and this money is then used to buy other securities like stocks and bonds. So, the value of the mutual fund would depend upon the securities it decided to buy.
Investing in mutual funds is different from investing in a stock. A stock is just one security, but a tax saving mutual fund can be a collection of various securities. For example, if an investor buys only Microsoft stock before the company has a bad quarter. The investor will lose a great deal of money as his funds were invested in only one stock.
However, if that investor invests in various stocks out of which one is Microsoft and if the company has a bad quarter then the loss would not be so huge for the investor. He can still gain from other investments that he has made.
How Mutual Funds Make Money?
There are three ways with which a mutual fund can provide money to investors.
- Dividend Payments: When a mutual fund receives interest or dividend it divides the amount of that income with the investors. Now, an investor can decide while buying a mutual fund, whether they want the dividend payments directly or whether they want to reinvest those payments.
- Capital Gains: There can be capital gains in a mutual fund if a security goes up and the fund decides to sell that security. These capital gains are distributed annually among investors.
- Net Asset Value: When the market closes and mutual funds share purchases are finalized, every mutual fund’s financial worth is calculated which is known as its Net Asset Value. As the value of the fund increases so does the Net Asset Value and the investor and sell the funds and gain money.
How mutual funds can help in tax saving?
There are different types of mutual funds available but if you want to save taxes, you must invest in ELSS (Equity Linked Saving Scheme). It is a mutual fund scheme with which you can invest in equity and equity-related securities. The lock period of ELSS is three years which means that you need to keep your money invested for at least three years. This also means that you must buy stocks that have a three-year investment perspective. Before you decide to invest in an ELSS mutual fund you must check its terms carefully and also its past performance.
How to invest in mutual fund for tax saving?
1. Choose between active and passive investment: Tax Saving Mutual funds can be managed actively or passively. Actively managed tax saving mutual funds have a higher fee and are managed by professionals. The fund manager does the research and invests accordingly. Passive investing is quite restricted. Here the funds manager cannot use his direction and the fund is operated on an auto-pilot. Passive funds have a lower fee and deliver similar results just like active funds.
2. Define a budget: Mutual funds investment could be as small as $100. So it is up to you how much you want to invest. You may also match the amounts based on your tax calculations and decide how much should be invested to save you from taxes.
3. Buying mutual funds: Now that you have a budget, you need to find out about tax saving mutual funds to invest in. Sometimes, you can buy a mutual fund directly from a company that created it or you may consult a broker. Brokerage companies take complete care of your investment and provide you with various choices of mutual funds.
But, you must make sure that the broker that you select is affordable and is ready to provide you with complete information about the mutual fund before investing. Also, check how easy it is to consult the broker and know the current state of your investment. Whether they are providing you with a brokerage app or a website for all your investment needs.
4. Check the fee: As we discussed earlier that every mutual fund has a fee associated with it known as its expense ratio. You must understand how much a mutual fund would cost you before investing as there could be a possibility that the expense ratio of the mutual fund would eat away all your savings.
Based on the annual fee, tax saving mutual funds are classified into various categories like open-end funds, closed-end funds, load funds and no-load funds. Read about each of these carefully to understand the annual fee associated with each of them and make your selection.
What are the benefits of mutual funds along with tax saving?
Mutual funds are a good choice for tax saving investments because they offer many benefits. Here are some of the major advantages of using tax saving mutual funds:
- Mutual funds investments are simple: If you have found a mutual fund that is right for you, you do not have to worry much about it. The mutual fund managers will do all the work for you.
- You can take the help of a professional: Anyone can invest in a mutual fund. You need not be a finance expert for that. You can take help from a professional expert on your investments. If you are choosing to invest in an actively managed fund, the fund manager will take care of everything and will do their best to bring your maximum gains.
- Mutual funds are affordable: You do not have to have a certain income or a certain amount of money to be able to invest in a mutual fund. Anyone can do it and that too within their budgets. You may invest $100 or $1000. It is all up to you.
- Mutual funds are easy to buy and sell: If we compare tax saving mutual funds to other assets like a car or a house, it is much easier to buy and sell a mutual fund. And, of course, you can make monetary gains by investing in mutual funds.
- You can invest at multiple places: Mutual funds provide diversification. This means you are not restricted to investing in just one asset or company. You can invest small amounts of your money in multiple investments. This means, even if any one of your investments fails, you can still hope to earn better returns from other investments.
Hope this article helped you understand the basics of investing in mutual funds and tax saving. John, who works as a finance assignment helper for college students says that tax saving mutual funds are a safer investment option that everyone should opt for at least once in their professional career. There are many benefits of investing in mutual funds and one of the most important ones is diversification. But before you buy a mutual fund for tax saving make sure to check the complete information about that mutual fund including lock period, previous performance, expense ratio and net asset value.