Warren Buffett, one of the most intelligent investors of all ages, once said: “Risk is a part of God’s game, alike for men and nations.”

“Risk comes from not knowing what you’re doing,” he said.

Risk and return are inseparable. But more money can be made only through investments and not by just saving it in a bank. Among all asset classes, equities have given the highest return historically.

But equity investments are riskier than others. Therefore, it is not necessary that small investors invest directly in shares; they can do so through mutual fund schemes and thus leave the hard work of stock selection to professionals.

But one must clearly understand the tax rules before investing in mutual fund schemes as the net return from a scheme depends on its tax provisions.

In the Financial Act 2003-04, rules were amended to extend tax benefits to equity investments.

However, income from different categories of mutual fund schemes are subject to different tax treatments.

New schemes

Mutual fund houses are now coming out with schemes hitherto unavailable in the market. Tax advantages available to equity schemes may not be available to the new schemes such as gold exchange traded funds, real estate funds of ING Vysya and ICICI Prudential and Birla Sun Life Mutual Fund’s offering of 100 per cent investment option in overseas stocks.

Dividend

Income from a mutual fund scheme can be of two types — dividend and capital gains. Dividends in the hands of unit holders from any type of mutual fund scheme, be it a debt, equity or any other, is tax-free.

However, if it is a scheme that doesn’t invest at least 65 per cent of its corpus in equities of domestic companies, the fund house will have to pay a dividend distribution tax at the rate of 14.025 per cent on the dividend payout and the tax liability is deducted from the investment fund of the scheme.

But if a scheme has an investment of at least 65 per cent of its corpus in equities of domestic companies all the time, the fund house doesn’t have to pay any dividend distribution tax on the payout.

For example, if you receive Rs 100 as dividend from a debt scheme, the mutual fund will have to pay out Rs 114.025 — the incremental Rs 14.025 has to be paid to the government as dividend distribution tax.

However, if it is an equity scheme, the fund house can pay out Rs 100 only without any tax burden. The equity scheme thus saves Rs 14.025 towards the outgo from the investment fund.

Thus if you choose a debt fund over an equity scheme to get regular dividends, your investment is likely to grow less in the former than in the latter to the extent of the dividend distribution tax.

Investors who fall in the highest tax bracket should opt for the dividend option in mutual fund schemes.

Capital gains

The capital gains tax liability also varies according to the category of the mutual fund scheme. Unit holders of mutual fund schemes having at least 65 per cent of its corpus invested in equities of domestic companies do not have to pay any capital gains tax provided the units are held for more than 12 months (long-term capital gains) before selling them.

However, on redemption, the mutual fund house will deduct a securities transaction tax of 0.25 per cent.

If a unit holder wants to sell the units before 12 months (short-term capital gains), he or she will have to pay a short-term capital gains tax at a flat rate of 10 per cent on the gain amount, that is, the difference between the sale price and the purchase price.

But these tax sops are not available in mutual fund schemes that do not keep at least 65 per cent of its corpus in equities of domestic companies at all times.

In such a scheme, an unit holder will have to pay a long-term capital gains tax either at a flat rate of 20 per cent or at 10 per cent with inflation indexation.

If it is a short-term capital gain, the unit holder will have to pay the tax at 20 per cent or 30 per cent depending on which income tax bracket he or she falls in.

ELSS wins

It is thus clear that a unit holder gets the maximum tax benefit by holding on to an equity scheme for more than 12 months. The investment redemptions will be tax-exempt.

You can save more tax by choosing an equity-linked saving scheme and claim a deduction of up to Rs 1 lakh under section 80C of the Income Tax Act.

Thus, even if your investment doesn’t grow during the three-year lock-in period, you ensure an effective tax-free 30 per cent return (if you are in the highest tax bracket).