Equity Linked Savings Schemes…Special Status
ELSS (Equity Linked Savings Scheme) or Tax Saving Mutual Funds, as the name suggests, are equity-based mutual funds which invest a majority of the corpus in equity markets. These are the only set of mutual funds that help you avail tax deductions. ELSS Funds are special funds which are meant for tax saving purpose under Sec. 80C of IT Act. These mutual funds come in with a lock-in period of 3 years from the date of purchase. The investment route can be either lump sum investment or an SIP. The monthly investment could be as low as Rs. 500 and there is no maximum limit.
ELSS – The Modus Operandi
The amount invested up to a maximum of Rs. 1.5 Lakh in a year will qualify for tax deduction under Section 80C along with other instruments like Life Insurance Premium, PPF, etc. The ELSS Mutual Funds come with a 3-year lock-in period – you cannot sell the units within 3 years from the date of investment. If you are opting for an SIP in ELSS Mutual Funds, then each SIP installment will have the mandatory 3-year lock-in period. However, each investment (monthly SIP) is considered as a fresh investment. Hence, each such investment or monthly SIP must complete 3 years for liquidating. Let us say, you started the monthly SIP on 1st January 2017, then the first SIP will be eligible for withdrawal after the completion of 3 years, i.e., after 1st January 2020. Same way 1st February 2017 SIP will be eligible for withdrawal after 1st February 2020. It will continue like that. One year SIP in ELSS funds means you have to wait for the completion of the fourth-year to completely withdraw the amount. You can also invest a lump sum amount in ELSS tax saving funds. One option for investment in ELSS is the Growth Option where the holder will not get any benefits in the form of dividends. The investor shall only receive the gains at the end of the tenure. This will help appreciate the total NAV and thus multiply the gains. The only caveat being since these returns would be subject to market conditions, it may work in the investor’s favour or maybe completely bad but it is possible that the profits might be great. In Dividend Option, the holder gets timely benefits in the form of dividends which are completely tax-free. Dividend Reinvestment option is an option wherein the investor gets the option of giving back the dividends received in order to add to the NAV. It is a good option if the market has been performing well and is likely to continue the same way.
ELSS – The Pros…
Equity Linked Savings Schemes are equity mutual funds which will not only help you to save tax but also provide a better opportunity to grow your wealth. Though there are many tax savings options available for investors who want to make use of the exemption limits provided under Income Tax section 80(C), ELSS funds serves as best tax saving mutual funds.
- Tax Savings under 80C– You can save up to ₹1,50,000 under section 80C in ELSS. This means savings of up to ₹7,500, ₹30,000 & ₹45,000 for investors in tax bracket of (5%, 20% and 30% respectively).
- Lowest Lock in– Amongst all the tax savings investment options under section 80C, ELSS has the lowest lock-in period of only 3 Years. To compare, Tax Saving FDs and ULIPs have 5 year Lock-in and PPF has a lock-in of 15 years (with option of partial withdrawal from the 6th year).
- Equity Exposure– For beating inflation and wealth creation Equities are the best option available; through ELSS funds you get the Equity Exposure with considerably less risk than direct equity investing due to the diversification provided by mutual funds. The returns from Equity are considerably higher than other asset classes over long term.
- ELSS funds fall under the EEE (exempt-exempt-exempt) category same as that of PPF. Under this, funds investment amount get a tax deduction, withdrawal amount is tax-free and no tax will be charged for capital gain also.
- The realised gains on ELSS are exempt up to Rs 1 lakh in a financial year. Gains exceeding Rs 1 lakh are taxed at 10 per cent. On FDs, the returns are added to the income and TDS is deducted yearly. The yearly deduction of TDS further reduces returns by making less money available for long-term compounding.Dividends obtained from ELSS funds are also tax-free.
- ELSS fund also offers SIP investment option, which brings discipline in regular investing.
- ELSS is the best tax saving instrument in terms of expected return, lock-in period and periodicity of investment.
…and the Cons
- ELSS invests money in the equity market only. This makes ELSS a risky investment option.
- The return offered by ELSS funds is variable in nature. In case of a stock market crash, you may end up earning a negative return.
- ELSS Funds have a 3 year lock-in period for lump sum and for each and every SIP.
You need to look at fund’s recent performance for a minimum of 5 years before investing in that particular fund. Choose funds which perform better than the benchmark and other similar funds in the same time period.
Choose fund houses which have performed consistently over a long period of time say 5-10 years.
It shows how much of your invested amount is being used to manage expenses of the fund. A lower expense ratio means higher take-home returns. Choose a fund with a lower expense ratio which can give you superior performance.
Consider various parameters like Standard Deviation, Sharpe ratio, Sortino ratio, Alpha and Beta to analyze the performance of a fund. A fund having a higher Standard deviation and beta is riskier than a fund having lower deviation and beta. Choose funds having a higher Sharpe ratio as they give you more returns for each additional risk undertaken.
The Asset under management is also taken into account while selecting best ELSS for investment. Higher AUM means higher the confidence of investor to that fund.
Tax-saving mutual funds, popularly known as equity-linked saving schemes (ELSS), had a good run over the past one year. Their average performance was heartening, and returns rose to an average 26% during the period compared to 16% delivered by the BSE Sensex and 21% by the large cap category. In fact, a large number of funds under the tax-saving category have returned more than 30% in the past one year. The outstanding performance of the tax-saving funds is not an aberration, though. For one, they have beaten their peers over long periods, as long as 10 years. For the past five years, these funds returned 20% compared to the broader market’s 13%, which means if you had invested Rs 1 lakh during this period, your corpus would have grown to Rs 2.48 lakh while the broader market would have given you Rs 1.84 lakh.
ELSS Funds for long-term wealth creation
To sum it up, carefully analyse your own risk appetite before selecting the ELSS funds. Although past performance of ELSS funds cannot guarantee their future performance, they can at least give you an idea of how a particular ELSS fund has dealt with past bear and bull market phases. Make sure to compare the performance of your chosen ELSS fund with its benchmark index and its peer ELSS mutual funds over the last 3 and 5 year period before finally investing in that fund. You may even choose to invest large amounts, above your tax deduction limit, but be mindful that your investment will not be accessible, and to that extent unchangeable, for the first 3 years of lock-in. Also, keep in mind, allocation to equity is most efficient over a period of more than 5-7 years. By keeping a long-term investment horizon, you can benefit from compounding and multiply your wealth. The performance of ELSS funds can vary wildly over the years. A top ELSS fund in one period may not necessarily be the best ELSS fund for the next period. Thus, you need to pick the right ELSS fund, one that has performed consistently and one that has generated a superior risk-adjusted performance. Because equity is highly risky, you will be better off investing systematically – putting in a small amount every month for a long period rather than paying a lump sum at one go. A monthly SIP will not only help you save money regularly but will also help you ride through the market volatility. Set aside a small part of your salary for the ELSS-SIP and watch your wealth grow. Overall, while ELSS funds are a great instrument for the combination of tax saving plus capital appreciation, two important aspects should always be considered before investing into them- (a) They all have a 3-year lock-in; and (b) They are, in the end, equity-oriented funds. To take maximum benefit from them it is advisable to not redeem the investments after 3 years but to give them a much larger horizon before considering redemption. This way you can truly combine tax planning with long-term wealth creation.