The New Year brings with it more work and diligence, especially in the area of tax planning. And it’s that time of the year when you have to be innovative with your investments to save tax. Instead of opting for the conventional tax-saving instruments like PPF, NSC, RBI bonds, and LIC policies, a better and remunerative way of investing your hard-earned money is the ELSS. An Equity Linked Savings Scheme (ELSS) is a tax saving instrument provided by mutual funds. It offers the benefits of getting equity linked returns and with the additional benefit of tax saving. Here is an analysis of the nitty-gritty involved in an ELSS, which would give you a perspective as to why it is a better alternative to other tax-saving instruments.
The fundamentals
An ELSS has a lock-in period of three years, which entails a minimum investment of Rs 5,000. The investor gets tax benefit by investing in ELSS, reducing his burden to a large extent. In addition to this, the investor earns capital appreciation over a period of three years. After three years, it can be redeemed or may be continued. The same three-year lock-in is available in close-ended schemes also but there is no tax benefit as the investor can exit the scheme any time but there is a higher exit load. In case of ELSS, you can’t remove the money in less three years of your investment period irrespective of how much return the scheme has generated.
According to your risk appetite there are three options available to choose from: growth, dividend and dividend reinvestment. Some investors are very risk averse. They want a regular flow of funds to maintain confidence on that particular scheme. This type of investor may go in for dividend. Dividend is declared depending upon the fund house. Dividend is generally declared at least once in a year. The percentage of dividend is based on the growth achieved by the scheme in less time. But he should understand that the increase in the NAV of the dividend option would be relatively slower than the growth option as there is cash outflow at regular intervals. And it reduces the chances of higher compounded growth over a longer period.
Another option is dividend reinvestment (div reinvest). There is little difference between this and growth option. If the fund declares a dividend then the dividend will be reinvested back into the scheme but at the current NAV price.
Growth option is the best and the most used one as your investment value grows faster. It is seen that majority of the investments happens in March as the main objective is tax benefits and not returns. They invest a lumpsum amount. Ideally, an investor should invest in such a manner that it should generate high returns with low or no pressure felt as far as cash position is concerned.
Investors can also go in for Systematic Investment Plan (SIP), where investment can be made in small installments at regular intervals on a fixed date for a certain period: half-yearly, annually, etc. Also intervals can be weekly, monthly, and on quarterly basis. SIP is easier than lumpsum as it eases the outflow of cash over a period. Besides, SIP allows the investor get units at lower NAV in a volatile market, thus getting more units.
Investing in ELSS attracts entry and exit load. Every fund house has a different load factor, varying from zero to 2.5%. Exit load may be in the range of 1% to 1.5%. The load percentage is very less but for higher amounts the load turns out to be big. So be aware of the load factor while investing.
Tax benefits
Investors making investments in tax saving mutual funds can avail of a deduction of up to Rs 1 lakh under Section 88 from the gross total income. The tax benefit is 33% if the gross taxable income comes in the highest income tax bracket of 30%. In addition to this, the capital appreciation you get on your investment will be totally tax-free after one year. Also, the dividend distributed does not attract dividend distribution tax.
The two most important benefits, which differentiate mutual fund ELSS and conventional instruments, are holding period and the returns. Today’s investors abhor a longer holding period and lesser returns if invested in PPF and NSC instruments. Investors should be ready to take certain amount of risk for higher returns and this risk is nullified when invested for three years.
Criteria
Currently, almost every mutual fund house has a tax saving scheme. So you have a gamut of options of various fund houses to select from. Now the biggest and the most challenging question: which scheme to go for?
There is no doubt that most schemes perform and give decent returns in a bull market. However, the best fund is that which sustains in the long term and gives decent returns over a period of three years.
Do your homework before selecting a scheme, as there are certain things to be looked at. The most obvious is the brand image of the fund house in the market.
Short-term performances can be ignored up to a certain limit, but not the brand and the value it has in the market. There are several cases where a certain fund-house becomes a ‘flavour of the month’ and then after a while starts deteriorating as the fund manager cannot sustain the returns. Or, the returns were a function of some wild bets that worked. A strong brand is created only when there is a consistent reward that investors have got. Simply going by a brand without any track record can be dangerous, as investors in the early nineties learnt when they invested in a top-rung global fund management firm, only to see their investment value fall drastically.
The next thing to look at is the returns delivered by that particular scheme. Generally, the investors look at the short-term returns generated by the scheme, primarily monthly or three-month gain. However, they forget that the investment is for a span of three years. Thus they overlook the best performing fund over the long term.
Another important criterion while choosing an ELSS is the asset size. Should you choose a large asset sized fund or one which has a smaller base? Typically, it would seem that larger the asset size better is the fund. It might not be the case. Managing a large asset size can be arduous.
Some fund managers keep higher percentage in cash and cash equivalent due to larger size. Higher percentage of cash will lead to relatively less increase in the net asset value over a period of time because there is no benefit in holding cash. Hence, it is good to look at lower- to medium-size asset size as the returns will higher. A medium size would be in the range of Rs 200-500 crore and a lower size would be less than Rs 200 crore. For instance, the asset base of ING Tax Savings is just Rs 74.17 crore as on December 2007. When it was launched the fund size was barely Rs 1.3 crore, but has managed to give 53% returns every year over the last five years.
Performance monitor
Mutual funds have given excellent returns in this bull-run since 2003 and tax saving schemes were also on the same track. Currently, there are 29 tax saving schemes in the market. Some schemes have performed well above the expectations and delivered outstanding returns in the last one, three and five years.
It is advisable to invest in a fund where there is a three year or more of track record to stand for. However, many investors are enticed by short-term return gains and often what their advisor pushes. Remember, some of the advisors gain commission from selling these products and are often known to recommend products that might not be suitable for you. And this applies to most other funds as well.
To select the right performance oriented fund requires data mining and in-depth research on the companies to find whether they provide good returns in the long run. Often, ELSS funds don’t churn their portfolio frequently as compared to open-ended non-ELSS schemes, where it is common due to liquidity pressure, hence it is paramount to look at their equity holdings with attention.
There are some schemes like the Taurus Libra Tax Shield and Principal Tax Saver, which have delivered 111% and 86% returns respectively in the last one year. If one looks at least a three-year track record, tax savings instruments have provided an average return of 46.44%.
Though, past performance may not be reflected in the future, the economic scenario in India looks strong and the markets are expected to outperform other forms of financial investments. Hence, ELSS will continue to remain a smart place to invest in.
Now, even after the three years of lock-in, you could redeem your current holdings and reinvest to avail of the tax benefit for that financial year. In this case, your investment will be continued at the current NAV price.
The other aspect
Like every good thing, there are caveats here as well. Some mutual funds claim to have declared dividend of 200% or more, urging you to invest with them within a record date to receive a specified dividend. When you come across such claims, proceed with caution.
After putting in money with the fund house with an entry load of 2.5% you get the dividend on the invested value. It means that you are actually incurring a loss of 2.5% if you are investing before the dividend is declared. So don’t get lured towards such promotional activities.
Purely from a tax management perspective, ELSS investment stands out as a preferred destination. Investors, who want to lock-in their funds and not succumb to the temptation of re-working and shuffling their holdings, will also find ELSS a good avenue for investment as there is the three year lock-in period.
For others who want liquidity as well as growth and the freedom to shift through funds, then there are other avenues available as well. But from a tax saving perspective, this is a ?must-have?.
