Decoding How Much of Your Salary Should You Invest in Mutual Funds?

Summary

The correct percentage of salary to invest in mutual funds will depend on one’s income, outstanding debts and age group. This guide covers typical allocation ranges, tax rules, and how to adjust contributions over time.

Key Takeaways

• Mutual funds have the potential to generate higher long-term returns than traditional savings accounts, although returns are market-linked and not guaranteed.
• A general rule is investing 10-35% of the income to mutual funds according to the salary level and debt.
• Firstly, get rid of all the high interest debts and form an emergency fund before making any long term investments.
• Utilize the salary increments and bonuses for increasing the mutual fund investments in steps without affecting necessary expenditures.

Introduction

Many salaried professionals keep all surplus in savings accounts or low-interest fixed deposits, which may lose purchasing power to inflation over time. Consequently, many investors turn to mutual funds, via SIPs or lump-sum allocations, seeking returns that can potentially outpace inflation over the long term. A common doubt that exists amongst most investors is how much of one’s salary should be invested in mutual funds per month without impacting the monthly rental expenditure, EMIs or daily expenditure?

The following guide will give you an insight on the proportion of your salary that should be invested in mutual funds and also how to scale it up as one’s salary increases over time. 

Importance of Investing in Mutual Funds

Mutual funds raise money from various investors and invest in equities, debentures or a combination of both. These investments are managed by the Asset Management Company (AMC) through qualified fund managers regulated under SEBI’s mutual fund framework. Investing in mutual funds helps in addressing several problems faced by many salaried people.

• Market access without any technical knowledge: The fund manager keeps tracking stock and bonds market daily, researching on company performances and the general trends in the market. Several full-time workers may have difficulty managing the markets all alone.
• Rupee cost averaging: Monthly SIP purchases more units when the market drops and less units when the market rises. This can help average the purchase cost over time, although it does not eliminate market risk.
• Tax efficiency, but only in the old regime: ELSS offers a ₹1.5 lakh deduction under Section 123, formerly 80C, with a three-year lock-in, the shortest among tax-saving options. The new regime is the default and allows no such deduction, so check which regime you are on before treating ELSS as a tax play. 

Traditional savings accounts and recurring deposits do not always keep pace with inflation, particularly after accounting for taxes. Equity mutual funds, held over a longer period, have historically returned more than many traditional savings options, though past performance is no guarantee of what comes next. For many investors, mutual funds serve as a core piece of the long-term investment strategy.

What Percentage of Salary Should be Invested into Mutual Funds?

There is no single number that fits every income group. Financial planners often use the 50-30-20 rule as a starting point: 50% of take-home pay for needs, 30% for wants, and 20% for savings and investments. Within that 20%, many investors allocate a significant portion to mutual funds once an emergency fund is in place.

The percentage of salary that should be invested depends on three things: monthly fixed expenses, existing debt, and the number of dependents. 

Note that CTC is annual and gross while the allocation is on monthly take-home, which for most salaried employees runs well below the CTC-implied figure after PF, tax and gratuity.

The suggested allocation also depends on existing EMI obligations. Someone with a large home loan may not be able to allocate a larger share of their salary into mutual funds without straining their monthly budget. In that case, a smaller allocation to equity and hybrid funds may be more manageable than an aggressive investment target. 

Financial Strategy: Allocating Your Salary for Mutual Fund Investments

A percentage is generally more useful when considered alongside an overall financial plan. One approach to salary allocation for mutual fund investing splits money into three parts before any of it enters a fund: an emergency reserve, short-term goals funded through debt or hybrid funds, and long-term goals funded through equity funds.

A commonly recommended approach includes the following steps: 

• Build an emergency fund before making significant long-term investments. 
• Pay off high-interest debt, especially credit card dues.
• Start a SIP in diversified equity funds at a percentage that is manageable.
• Increase the SIP amount gradually as salary increases.  

Start with an emergency fund from your first salary. Keep it in a separate savings account, untouched except for emergencies. A common recommendation is to keep around three months of expenses if single, six to twelve months if married with children, and over twelve months for freelancers or those with unstable income. 

Consider investing the amount that remains after meeting the emergency fund and essential financial priorities. Investors without an emergency fund may need to redeem equity investments during unexpected financial situations, which could result in losses if markets are down at the time of redemption. 

Adjusting Your Investment Plan According to Income

Consider the following before increasing or reducing your SIP amount:

• Many investors use salary hikes as an opportunity to increase SIP contributions instead of increasing discretionary spending.  This is the step-up SIP method.
• Bonuses and salary increments may be added to existing SIPs instead of starting multiple new investments, making the portfolio easier to manage.
• A drop in income, such as a job change or a pay cut, calls for a review of the SIP amount before the next debit, not after a missed payment.
• Once the emergency fund and debt have been cleared, a larger portion of the income can be allocated to equity funds, as the buffer against unforeseen expenses has already been created.
• Once the amount and fund category are settled, comparison tools can help narrow the shortlist; comparing the best SIP investment plans is a reasonable starting point.

Risks and Returns: Balancing Your Mutual Fund Portfolio

All mutual funds involve risk, and the risk increases with equity exposure. Large-cap funds are generally less volatile than mid-cap or small-cap funds. However, future returns depend on market conditions and there is no guarantee that one category will consistently outperform another. Debt funds carry interest rate and credit risk rather than equity risk; their NAVs still move daily, just for different reasons, and gains on most debt fund units are taxed at the investor’s income tax slab rate, regardless of how long units are held, under Section 50AA.

The tax rules are different for equity funds. Gains on units sold within 12 months are short-term, taxed at 20% under Section 196 (formerly 111A). Beyond 12 months, they are long-term, taxed at 12.5% under Section 198 (formerly 112A), with the first ₹1.25 lakh of long-term equity gains in a tax year exempt.

Expense ratio also affects returns, even though it has nothing to do with risk. A direct plan usually has a lower expense ratio than a regular plan, and this difference may have a noticeable impact over longer investment periods. Checking the expense ratio is an important step that some first-time investors may overlook. 

Conclusion

Choose a SIP amount you can invest consistently, even in case of reduced income. For many investors, it might be easier to start with a small amount and then increase the SIP contribution as the salary increases rather than starting with a much larger commitment. Revisiting the allocation regularly helps to ensure that the investment plan continues to be in line with changes to income, expenses, and financial goals