Amid the quest to achieve various crucial life goals through wealth creation and also reduce their income tax through tax saving instruments, many people often have to compromise on one of these two aspects when planning financial. While some financial instruments are sufficient on the wealth creation front but do not offer enough or no tax benefit, some, on the other hand, offer sufficient tax benefits but not enough returns for wealth creation, especially after taking account for inflation and the taxation of interest income. However, one tax saving instrument which adequately offers the dual benefit of wealth creation and tax saving is the ELSS (Equity Linked Savings Schemes). Let’s take an in-depth look at and understand ELSS funds and why you should invest in them.
What is ELSS?
Simply put, Equity Linked Savings Plans (ELSSs) are tax-saving equity mutual funds that invest a major proportion of their portfolio in stocks or equity-linked instruments across different industries. , market capitalizations, etc. Being equity-focused funds, ELSS comes with the same market risk as other equity funds, but their returns generally outperform not only inflation but also the various fixed income investment options in Section 80C, as well as other asset classes, with a large long-term margin.
Main characteristics of ELSS funds
-3 year lock-in period, which is the shortest of all the investment options available under section 80C. Once the blocking period is over, the ELSS funds can be easily refunded with the refund amount credited to the linked bank account within days.
-ELSS offers the advantage of claiming tax deductions of up to Rs 1.5 lakh per fiscal year under Article 80C of the Income Tax Act.
-Possibility of investing in flat-rate mode or via the SIP channel (Systematic Investment Plan).
-No tax levied on earnings up to Rs 1 lakh during a fiscal year. However, any long-term capital gain greater than Rs 1 lakh results in a 10% LTCG tax. (Rating gains made from shares repurchased after 1 year of investment are called LTCG).
-As a category, ELSS has generated average annualized returns of approximately 60.53%, 16.28%, 15.28% and 14.41% per annum over the last 1 year, 3 year, 5 years and 7 years respectively. (According to valueresearch data from 08.09.2021).
What to consider before investing in ELSS funds?
1. Investment horizon
Since ELSS are equity-focused mutual funds and stocks have a proven track record of higher returns with less long-term volatility, make sure you have at least an investment horizon. in the medium and long term of 5 years and more when you invest in ELSS. In addition to taking into account the mandatory three-year blocking period in ELSS funds, aim to stay invested for the long term instead of redeeming at the end of the blocking period. Keep in mind that having equity exposure in ELSS funds allows investors to mitigate market volatility by staying invested longer. Investing solely for the purpose of saving tax and paying off quickly after the lock-in period would prevent you from maximizing the potential return on equity investments that would otherwise have been generated over the long-term investment horizon.
When investing in ELSS funds, remember that returns are entirely dependent on the performance of the underlying securities, ie stocks. Returns shown are based on past performance, so they do not guarantee returns. It is an indication of potential returns, which would possibly depend on the performance of the fund and the market scenario. Since equities have shown much higher returns than other asset classes over the long term, it is advisable to stay invested in ELSS funds for a longer investment horizon.
In addition, be sure to periodically review your portfolio and the plans chosen. If the funds have consistently underperformed for the past few quarters, you may want to consider buying them back and switching to better performing ELSS funds to ensure wealth creation.
3. Risk appetite analysis
Since different ELSS funds have different investment strategies, the market risk associated with their portfolios may differ between many ELSS funds. Therefore, ideally, those with a low or moderate risk appetite are advised to invest in ELSS funds with a predilection for large cap stocks, as these tend to involve a relatively high degree of risk. lesser. While those with a high risk appetite can go ahead with ELSS funds with a tendency towards mid / small cap stocks and / or multi-cap funds, as these typically involve a degree of higher risk.
Now that you have gained the basic understanding of what ELSS is and how it works, it becomes imperative to go ahead and know its benefits and how it outperforms other tax saving schemes such as ULIP, PPF, 5 year tax saving FD, SCSS, SSY, NPS etc. by a wide margin.
Benefits of ELSS and how it outperforms other tax saving investment options
1. Greater liquidity thanks to the shortest blocking period
ELSS mutual funds have the lowest locking-up period of just 3 years, compared to other tax-saving investment options, such as PPF (15 years), Tax-saver FD, ULIP and NSC (5 years each). While investment in the National Pension Scheme (NPS) remains blocked until retirement. With their investments locked in for the shortest period among its peers, ELSS offers a higher degree of liquidity to its investors in the event that they need to redeem their investments for various reasons during a three-year post-lock term.
2. Higher returns and wealth creation potential than its peers
Since ELSS primarily invests in equities and equity-related instruments, it is able to comfortably outperform its peers like ULIPs, tax-saving FDs, PPFs, etc., in terms of higher returns than long-term inflation. Additionally, despite the re-imposition of the 10% LTCG tax on earnings above Rs 1 in a fiscal year, ELSS’s after-tax returns are still significantly higher than its peers, especially on long horizons. long-term investment. over 5 years old.
3. The SIP route instills disciplined investment
Like other categories of mutual funds, ELSS funds also allow the investor to choose the flat-rate investment mode or SIP (Systematic Investment Plan). SIPs involve a periodic and automatic investment, as the amount is debited automatically on the predefined date and frequency (usually monthly). This mechanism allows SIPs to establish financial discipline by encouraging the investor to save and invest regularly. Additionally, the concept of averaging rupee costs of SIPs leads to an average of the cost at which mutual fund shares are purchased, thus negating the need to time the market even during market fluctuations.
Smart steps to follow when investing in ELSS funds
1. Don’t rush into redemption when the lock-in period ends
Many investors make the mistake of exiting / redeeming their ELSS investments as soon as their 3 year lock-up period expires. Those investors who rush into the decision to redeem at the end of the lock-in period should remember that equity mutual funds are best suited for achieving long-term goals of 5 years and more. Therefore, redeeming ELSS funds after 3 years may not leave enough time for your investment to grow and generate the expected returns. It would therefore be prudent to remain invested as long as possible, until the desired corpus has been accumulated. However, it would be prudent to redeem in the event that your program has consistently underperformed its benchmark and peers.
2. Make sure that tax savings are the main but not the only objective of the investment.
Every investor should adopt a goal-based investment strategy while investing. Even though the main reason for investing in ELSS funds is largely tax savings, investors should ensure that the goal of wealth creation needs to be considered equally, in order to achieve goals. long term such as higher education and child marriage. However, it is prudent to act diligently before investing in ELSS, ensuring that your financial goals are aligned with the investment and that you have carefully assessed the associated risk, expected returns, etc.
3. Stay invested even after retirement
Contrary to popular advice that investors should buy back their equity investments and turn to less risky alternatives such as debt funds and fixed income products after retirement, it’s best not to. This is because more often than not the fixed income products you transfer your ELSS and other equity investments to fail to beat inflation rates. This can lead to losses after tax deductions for those in higher tax brackets. Plus, if you end up living longer than your expected life expectancy, the longevity risk of missing out on your retirement corpus could worsen your financial life.
Therefore, those who invested in ELSS before their retirement should not leave them completely. Instead, whatever part of your corpus is intended to be consumed in the long term, i.e. five years or more, it should remain invested in equity funds, because stocks as a asset class have consistently beaten their peers by delivering returns above inflation. on the long term. The rest of the corpus can be redeemed and moved to less risky avenues.