Why you must seriously consider ELSS for tax planning…

Over the last 3 years, mutual funds have seen a sharp inflow of funds. Interestingly, most of the inflows have come into equity funds and they have come from retail investors via SIPs. One of the sub-categories of equity funds is the equity linked savings schemes (ELSS). An ELSS is an equity fund which has a lock-in of 3 years and also proffers a tax benefit under Section 80C of the Income Tax Act. Here is why you must seriously consider ELSS for planning your taxes…

It is a systematic way of generating wealth in the long run…

ELSS funds are unique in two ways. Firstly, it is the only equity investment that offers tax benefit to investors under Section 80C. Other similar schemes have not been too successful. Thus it gives you the benefit of a tax reduction with long term wealth creation. Secondly, ELSS funds have a unique advantage in that the lock-in induces a long-term approach to investing by the fund manager. Since investments are, by default, locked in for a minimum period of 3 years the fund manager does not have to focus too much on liquidity maintenance. This enables the fund manager to take a more long term view of equity investments. Investors need not just look at ELSS as a tax saving method but also as a genuinely long term wealth creator with the added benefit of tax benefits. Let us understand these tax benefits in a better way as they go a long way in enhancing the effective yields on the investment.

How ELSS enhances the effective yield on the investment…

To understand the effective yield on the ELSS investment, one needs to better understand the tax benefits on investing in ELSS funds. Any investment in ELSS funds can avail a rebate of up to Rs.150,000/- per year under Section 80C of the Income Tax Act. To understand the impact of ELSS, let us compare the returns on a normal mutual fund and the ELSS to understand how the tax rebate enhances the effective return…

Equity Fund Values ELSS Fund Values
Investment in INR 100,000 Investment in INR 100,000
Value after 3 years 160,000 Value after 3 years 160,000
Total Returns 60,000 Total Returns 60,000
% returns in 3 years 60% % Returns in 3 years 60%
CAGR Returns 17% Annualized CAGR Returns 17% Annualized
Tax Rebate Tax Rebate u/s 80C 30,000
Effective Yield 17% Annualized Effective Yield 32% Annualized
ELSS Advantage – 15% Annualised

Let us break up the above example. By opting for an ELSS equity fund instead of a normal equity fund, you can earn an additional 15% returns per annum even when the mutual fund performance is the same. How does this happen?

When you invest in ELSS, you get 30% rebate on your investment (for simplicity we assume the person is in the 30% tax bracket and we ignore the impact of cess). Therefore in the year of investment, the ELSS investor actually invests Rs.70,000 and not Rs.100,000. This is where you get the big advantage as the benefit of Section 80C actually tend to get front-loaded on to your returns. Which is why the tax shield on ELSS substantially adds to your effective post-tax yield on your investment?

ELSS makes more sense as a SIP…

One of the best ways of executing an ELSS is through the SIP route. What exactly is the SIP route? The systematic investment plan (SIP) entails investing a fixed sum of money each month rather than investing lump-sum. For example, if you intend to invest Rs.120,000/- for the full year, you can start an ELSS SIP of Rs.10,000 per month to achieve your target. Adopting a SIP approach to ELSS has the following key advantages…

  • It tends to match your outflows on account of the ELSS SIP to your monthly cash inflows. Thus you are saved the hassle of rustling up the funds at short notice during the end of the financial year.
  • The lock-in period of your ELSS is for a period of 3 years from the date of investment. This will ensure that your lock-in expires in tranches and the lock in also ends earlier.
  • Lastly, the benefit of rupee cost averaging is available on your ELSS when you take the SIP approach. The benefits may appear to be marginal but when cumulated over a number of years, the effect tends to be substantial.

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