Tax planning is one of the most important aspects of financial planning. Before making any investment decision you should know final outcome post tax. Just to remind you long back there were two RBI bonds available in the market; one is 6.5% tax free and another one 8% taxable. Because of tax advantage in first option there was a huge inflow in tax free option as to a person in 30% tax bracket was getting additional 0.90% compared to taxable 8% option (net 5.60%). Government had to withdraw the tax free bonds after they realize that smart money is heavily coming in tax free option and government is losing on income tax revenue. You can't afford to ignore tax planning even you are in lowest tax bracket.

The budget of 2014 made debt funds long term after a period of 3 years instead of previous clause of 1 year. This single amendment changed the entire investment pattern in debt funds and FMPs. We had floods of 1 year FMPs in the market prior to this amendment and also sizable amount came in MIP funds (Monthly Income Plans) due to its tax advantage. The advantage in FMPS and MIP funds had a blow after the change in long term definition of other than equity funds. This advantage has gone now and again the sizable amount has moved to bank fixed deposits which attract tax liability. So is there any other option available to save tax. The answer is yes.

After debt funds are made long term after 3 years, a new category of investment has arrived in the market in the name of equity income fund. J P Morgan and ICICI prudential are the first to launch this investment option in the market. The equity income funds are similar to MIP funds but these new funds are treated as equity funds for tax purpose. The fund is classified as equity fund if it invests 65% of the fund in equity category and for income tax purpose the fund will be treated long term after a period of one year. So what is the difference if the risk is almost same like MIP funds? These new equity income funds invest up to 25% in equity and up to 40% to 50% in arbitrage which are treated as equity investment and thus classify as equity oriented fund for income tax purpose. The equity income fund invests balance in debt products like government and corporate bonds or money market instruments.

The arbitrage means buying in cash market and selling the same quantity in future and option market. So if any fund does arbitrage means there is no equity risk as the equity position is hedged in F&O segment. This arbitrage will give you debt kind of return depending on the premium available on the stock. So as far as risk is concerned it is same like hybrid aggressive debt oriented funds i.e. MIP funds but tax treatment is like equity funds and not of debt funds. This tax treatment gives equity income fund an edge over MIP funds and FMPs.

But surely this product is not meant for one year time horizon even it gives tax free return after one year. Equity investment always is risky investment and even 25% investment can give you negative return if your time horizon is one year. The equity income fund is suitable for those whose time horizon is 2- 3 years and can extend for another six months if needed. The bank deposit will give around 6% return post tax and 3 year FMP will give around 8% return but this fund can give you 2% more if you take calculated risk. The returns in equity income funds are not guaranteed as the funds are market linked. Investors should definitely consider if they understand the risk involved during this 2-3 years period. The funds are very new and have not completed one year so past performance is not available for comparison. Comparing this fund with aggressive MIP funds will give you rough idea about the risk and reward. Normally I don't recommend any fund which has not completed 3 years time but this new category is almost same like MIP funds so it's easy to understand and tax treatment is added advantage. Corpus of around Rs. 10 billion in less than one year period indicates that smart money has started coming in this funds. Hope with growing demand other AMCs will also follow the suit.

(Pankaaj Maalde is a certified financial planner)