An ideal tax-saving instrument should provide high returns, liquidity and tax savings. One instrument that fits this criterion is Equity Linked Saving Schemes (ELSS). ELSS is a type of mutual fund in India that is eligible for tax benefits under Section 80C of the Income Tax Act, 1961.
To ensure that your money is working towards a single goal, which is wealth creation, it's important to have an orderly approach. Tax saving should be aligned with your overall financial strategy, rather than a last-minute effort at the end of the financial year where you choose any option without proper consideration. Tax optimization of financial products should be the final step in your financial plan and not the primary criteria for selection. However, most individuals do not approach tax planning from an investment perspective and end up picking investments that offer only the needed tax deduction for income tax purposes without considering whether such investments align with their overall financial goals. This is why many investors opt for Unit Linked Insurance Plans (ULIPs), endowment plans or National Savings Certificates (NSC) in addition to their Employees’ Provident Fund (EPF) and Public Provident Fund (PPF). The fact that equity funds and equity -related funds provide high returns cannot be ignored when you look to invest in mutual funds in order to achieve your financial goals or achieve financial freedom. Therefore, instead of solely focusing on tax savings, you must give priority to your financial goals and try to incorporate them into your tax-saving plan. This approach will help to ensure that your tax-saving efforts are in line with your overall financial planning. Compared to other options available under this section, ELSS is a better choice for tax savings due to its higher returns and ability to reduce tax liabilities. This article will highlight the benefits and strategies of investing in ELSS and how an investor can make the most out of it.
What is ELSS?
Equity Linked Saving Scheme is special open-ended equity fund scheme which primarily has 80 percent of its investment in equity and equity-related securities and provides the investor with tax deduction benefits under Section 80C of the Income Tax Act, up to Rs 1,50,000/-. It is a great option for those who want to save on taxes while also earning higher returns compared to traditional tax-saving options like Public Provident Fund (PPF) and Bank Fixed Deposits (FDs). These traditional options typically offer returns between 8-9%, while ELSS, being linked to the equity market, has the potential to provide higher returns. ELSS funds have a lock-in period of 3 years, which means that the investment cannot be withdrawn before the completion of 3 years. These funds generally have a diversified portfolio and tend to have a higher risk-return profile compared to other traditional tax-saving options mentioned above. The returns generated by these funds are taxed as long-term capital gains (since they are held more than one year) which is currently taxed at 10%.
Benefits of investing in ELSS:
There are several reasons why one should consider investing in Equity-Linked Saving Schemes as a part of their investment portfolio:
Tax Benefits: ELSS investments qualify for tax deductions under Section 80C of the Income Tax Act, up to a maximum of Rs 1.50 lakhs per financial year.
High returns: In addition to being a great option for those who want to save on taxes, ELSS have the potential to offer higher returns than other traditional tax-saving investments like PPF or NSC and bank fixed deposits as these funds invest primarily in equity. One may argue that equity investments are volatile in nature, but it's important to keep in mind that these investments are made with a minimum time horizon of three years. Therefore, while returns may be negative for a short period, over the long term, ELSS tend to generate better returns than its traditional counterparts.
Diversification: ELSS funds invest in a diversified portfolio of equities, which helps to spread the risk and reduces the impact of a fall in any one stock or sector. It is a diversified and market-linked investment option that can benefit all types of investors. It is especially beneficial for young earners and new joiners who are just entering the workforce and coming under tax slabs, as it not only allows them to save on taxes but also helps them build a corpus for their long-term financial goals. For those in their 30s to 60s, ELSS is a great way to save on taxes and add equity exposure to their investment portfolio. For senior citizens, ELSS provides liquidity after three years and offers tax savings that traditional tax-saving options like bank fixed deposits do not.
Lock-in Period: ELSS funds have a lock-in period of 3 years, which helps to create a long-term investment mindset. ELSS have a shorter lock-in period of three years among tax-saving options compared to 15 years for PPF and 5 years for NSC, making them more liquid.
Equity exposure: ELSS is one of the few tax-saving options that gives investors exposure to equity markets, which is important to build wealth over the long term.
How to invest in ELSS?
When it comes to investment amount, ELSS can be invested in through Systematic Investment Planning (SIP) with as little as Rs. 1000 per month, which will be automatically deducted from your bank account. This helps to build a discipline approach towards regular investments. Alternately, you can also make lump-sum investments in ELSS.
It is advisable to invest in ELSS via a SIP starting from the first month of the financial year i.e., April. However it is necessary to keep in mind that if you are investing in ELSS through SIP, each SIP installment will be locked-in from the date of that particular investment for 3 years, and the lock-in period for the entire amount invested during the financial year will not end after 3 years from the date of the first SIP installment.
When choosing an Equity Linked Saving Scheme, it is important to consider your personal investment goals. If you are looking for annual returns with tax savings, the "Dividend" option may be best for you. On the other hand, if you are looking to build a lump-sum corpus with equity exposure, the "Growth" option may be a better fit.
How to choose which ELSS to invest in?
Fund Performance: It would be wise to invest in a relatively old ELSS fund which has a tracking record available for at least 5 years. This would help an investor to evaluate the consistency of the fund to generate returns over different market periods and situations. Tracking historical returns also helps an investor to avoid getting into the trap of recency bias and invest in a fund based on one or three -year period returns chasing higher returns. Consistency is the key while investing in mutual funds and seeking long-term wealth creation. The fund must be a consistent performer and must be able to beat its benchmark (like CNX 500 Index; S&P BSE 100 Index, etc) over a long term period like 5 years by a good margin. It would be even better if the fund is able to beat its benchmark over 1-year, 3-year and 5-year period. Funds with high compounded annual rate of return are preferable.
Fund Manager: It is also important to know the history and performance record of the fund manager of the ELSS fund you plan to invest in as it is the fund manager that makes a big difference to the fund’s performance.
Fund Portfolio: It is preferable to invest in an ELSS fund with a large fund size as it allows better diversification and economies of scale. Since ELSS is primarily an equity fund that invests in large cap stocks, a large fund size is an advantage.
Portfolio Turnover Ratio: It would also be important to consider factors like the level of diversification across sectors and stocks, market segments in which the fund invests, cash holdings, the fund’s investment strategy and also the holding period of stocks in the portfolio. This can be known from the portfolio turnover ratio. A lower than category average ratio implies that the fund manager follows a buy and hold strategy and this can help to curb high trading costs. Its best to choose a fund whose goals align with your overall financial goals.
Risk and Returns: The level of risk undertaken by the fund can be known from standard deviation and beta while its risk-adjusted returns can be derived using Sharpe Ratio and Treynor Ratio. It is worthy to choose funds whose level of risk is lower than category average while level of risk-adjusted return is higher than category average at least over a three year period.
Expense Ratio: The fund must be a relatively low-cost fund meaning that its expense ratio must be lower than ELSS category average.
How to turn 3 years of ELSS lock-in into a Permanent Tax Saving Strategy?
One way to take advantage of the tax benefits offered by Equity-Linked Savings Schemes without having to invest a large amount of money every year is by withdrawing Rs 1.50 lakhs from ELSS after the 3-year lock-in period and reinvesting the funds in ELSS. For example, let's say you invest Rs 1.50 lakhs in ELSS in the financial year 2022-23. The lock-in period for this investment will end in the financial year 2025-26 and the said investment will be available for withdrawal. You invest another Rs 1.50 lakhs in ELSS in financial years 2023-24 and 2024-25, respectively. The investments made in these years will be available for withdrawal in 2026-27 and 2027-28. By doing this, you would have invested a total of Rs 4.50 lakhs in ELSS over the course of three years and would be eligible to claim a tax deduction of Rs 1.50 lakhs each year. In 2025-26, you would withdraw Rs 1.50 lakhs from ELSS as the lock-in period ends for investment made in year 2022-23. You reinvestment this amount in ELSS and claim tax deduction for year 2025-26. Next year you repeat the same process, withdraw the investment made in year 2023-24 and reinvest in ELSS and claim tax deduction for year 2026-27. This way, you would be only investing Rs 4.50 lakhs in total and recycling the investment every year to claim the tax deduction.
However, there are a few points to keep in mind when considering this strategy:
Tax optimisation only: This strategy is suitable for claiming tax deduction only and does not lead to wealth creation. If your goal is solely tax optimisation, this strategy may be appropriate. Wealth is built by making and holding investments over a long period of time.
LTCG tax: It is important to adjust for the long-term capital gain (LTCG) tax of 10% when recycling ELSS investments. This tax will apply to the gains made on the sale of the units and will need to be paid before reinvesting the remaining amount.
Market fluctuations: As the value of ELSS investments can fluctuate due to changes in the stock market, it is important to keep an eye on the value of the investments and ensure that they are sufficient to claim the full tax deduction. If the value of the investments decreases, it may be necessary to make additional investments in order to claim the full deduction.
Other considerations: It is also important to consider other factors such as the performance of the particular ELSS fund and the individual's overall financial goals and risk tolerance when deciding whether to use this strategy.
Thus, recycling ELSS investments can be a useful way to claim the tax deduction under Section 80C without making new investments every year, as long as it is done in a careful and disciplined manner. It is always a good idea to consult a financial advisor or tax professional before making any investment decisions.
Conclusion
While there are various tax-saving instruments available under Section 80C, such as PPF, NSC and ULIPs, ELSS stands out as the preferred option. The reason being, ELSS offers a combination of tax savings and investment opportunities, whereas other options such as PPF, NSC, and ULIP, while carrying lower risks, tend to have lower returns on investment in the long run.
From a behavioural finance perspective, ELSS serves as a good starting point for individuals to invest in equities and mutual funds. The tax savings aspect of ELSS may attract investors and its short lock-in period in comparison to other options may make it more appealing. As the equity market generally offers higher returns in the long term, investing in ELSS for a period of three years can lead to good returns, which may encourage investors to continue investing in mutual funds in general, and instill investing discipline in them.
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