Equity Linked Savings Scheme: Why ELSS is the best tax-saving investment option

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Updated: Jan 07, 2021 12:33 PM

Let’s look at ELSS funds closely and understand how they offer a superior tax-saving option than others, and what factors to consider before investing in ELSS.

Among all the Section 80C options, ELSS comes with the lowest lock-in period of just 3 years.

Most of the taxpayers evaluate various tax-saving investment options as they get closer to the last quarter of the financial year. However, with limited financial literacy and multiple options available under Section 80C, investors often end up investing in sub-optimal tax-saving options generating lower returns with restricted liquidity.

Today, let’s look at ELSS funds closely and understand how they offer a superior tax-saving option than others:

Lowest lock-in period

Among all the Section 80C options, ELSS comes with the lowest lock-in period of just 3 years. Other investment options eligible for Section 80C deductions like ULIP, NSC, tax-savings FDs come with a lock-in period of 5 years. Meanwhile, PPF comes with a lock-in period of 15 years whereas NPS stays locked-in till retirement with very limited options for premature withdrawals. Thus, ELSS funds offer the highest liquidity among all the investment options eligible for Section 80C deductions.

Higher wealth creation potential

Being diversified equity funds, ELSS primarily invests in equities and equity-linked instruments from across the market capitalization, sectors and themes. As equities as an asset class beat fixed income instruments and inflation by a wide margin over the long term, ELSS funds can generate higher returns than other Section 80C fixed income instruments like NSC, PPF, tax-saving bank FDs, etc. The feature of 3 year lock-in period in ELSS also reduces the redemption pressure on their fund managements, allowing them to take a more long-term view of the market than other open-ended funds. All these features in combination make ELSS funds an excellent instrument for wealth creation and achieving long-term financial goals like creating corpuses for post-retirement life, children’s higher education, etc.

Tax-free returns on LTCG of within 1 lakh

Gains made from equities redeemed after 1 year of investment are considered as long-term capital gains (LTCG). LTCG on equities of up to Rs 1 lakh in a financial year is tax free whereas LTCG exceeding Rs 1 lakh in a financial year is taxable @ 10%. Among other Section 80C investment choices, PPF comes with tax-free maturities whereas interest earned from tax saving FDs and KVP are taxable as per the investors’ tax slab. For ULIPs, the entire maturity proceeds are taxable if the premium paid exceeds 10% of the sum assured.

Instils financial discipline

Like other mutual fund categories, fund houses allow the SIP mode of investment in ELSS. SIP enables you to invest a predetermined amount at regular frequencies regardless of the market condition to build a desired corpus over the time period. This periodic and automatic deduction of investment encourages you to save as well as invest regularly. By distributing your investment throughout a longer period, SIP allows you to benefit from rupee cost averaging during market corrections and dips.

Factors to consider before investing in ELSS

# Analyse your risk appetite

As ELSS funds have differing investment strategies, the market risk to ELSS portfolios might differ across ELSS funds. Thus, those with moderate to low-risk appetite should opt for ELSS schemes with large cap bias. Those with high-risk appetite can opt for ELSS funds following Multicap strategy or mid/small cap biases.

# Compare their past performance

When opting for ELSS funds, ensure to compare their performances over the past 3-, 5- and 7-year periods. While excellent performance in the past might not guarantee similar performance in the future, fund comparison helps in finding out how the fund dealt with various economic conditions in the past vis a vis peer funds and benchmark indices.

# Avoid opting for dividend option

Many investors wrongly perceive mutual fund dividends to be as windfall income. What such investors fail to understand is that dividends declared by the funds is the money paid from their own investment. As an outcome, NAV of the fund gets deducted by the money paid out as dividend. Moreover, dividends received by investors are taxed as per the tax slab of investors. Hence, investors should opt for growth option in ELSS fund and benefit from the power of compounding.

# Opt for direct plans of ELSS

The expense ratios of direct plans are usually up to 1% lower than their regular counterparts. As the direct plans of mutual funds do not incur distribution expenses, savings made under this head remain invested in the direct plans. These savings themselves start generating returns from their due to the compounding effect, thereby generating higher returns than the regular plans. Though the difference in returns might seem small in the initial years, the difference would become substantial over the long term.

(The author is Director, Paisabazaar.com)

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