Save Tax with ELSS

ELSS

We all work hard through the year, but as the financial year draws to a close, we find that we haven’t managed to save enough. This is because much of our income goes to the taxman. But then, there are ways in which you can reduce your tax bill. You can save a lot of money by investing in the right tax-savings products. They not only provide us with tax breaks, but also help create the discipline needed for a long-term saving habit. It’s again that time of the year when many of us start searching for the right tax-saving products. The choice hinges on your risk appetite, tax bracket and whether there is a need for regular income. If you are looking for a short-duration plan with returns linked to equity markets, you do not have to look far. Equity-linked savings scheme (ELSS) can be the product for you with a three-year lock-in period, returns linked to the equity market and tax benefits as well.

WHAT IS AN ELSS?

As is evident from the name itself, equity-linked savings scheme is a savings scheme that’s linked to equity. Investment avenues for your savings can be a mix of various asset classes such as equity, debt, gold and real estate.

ELSS is a mutual fund scheme which is similar to any diversified equity mutual fund that routes your investments into the equity markets. However, it stands apart from a normal mutual fund in one major way. ELSS carries a tax benefit on the amount invested. And therefore, you have to lock in your investment in an ELSS for three years.

CHARACTERISTIC FEATURES OF ELSS

• It acts as a proxy route to direct stock investments.

• Its lock-in feature gives you long-term investing discipline.

• It has tax-saving benefits and the potential for higher returns.

• It offers the flexibility to invest small amounts through a systematic Investment plan.

• Your lock-in for three years prevents withdrawals and allows your money to grow.

• Investments in equity over the long term delivers better returns than other saving instruments.

WHO CAN BUY?

Section 80C of the Income Tax Act provides tax benefits to a person who buys units of ELSS, either in his own name or jointly. Parents can also make investments in the name of a minor and avail tax benefits. The nomination facility is also available for single or joint owners of the fund. The Karta of a Hindu Undivided Family (HUF) can also buy these funds. Do have a copy of your PAN card to complete the investing process.

WHAT’S THE MINIMUM AND MAMIMUM I CAN INVEST?

You may buy units under this scheme with minimum Rs 500, and in multiples of Rs 500 thereafter. Investments can either be in lump sum or through the Systematic Investment Plan (SIP) route. Considering the volatility of the markets, SIP is a better way to invest, save tax and create wealth over the long term. Ideally, there is no right time to invest in equities through SIP. One can start right away, and also reduce the impact of equity market volatility on the investments. There is no maximum investment cap in these plans. However, the tax advantage is only up to Rs 1 lakh.

HOW IS IT DIFFERENT?

Normal equity mutual funds don’t have a lock-in period and neither do they carry any tax benefits. This means, you can withdraw from the fund any time. But if you go for an ELSS, you can’t withdraw for three years. But there are quite a few advantages. The lock-in period gives the fund manager a leeway to invest in stocks that are less liquid and undervalued. Fund managers don’t have to worry about redemption pressures for three years and, hence, can hold on to the stock for a longer period. Also, the fund manager’s long-term view while selecting stocks essentially gives precedence to long-term goals over short-term results.

HOW TAX IS SAVED

Investments in ELSS plans are eligible for deduction from the gross total income under Section 80C of the Income Tax Act. There is no limit for investments in ELSS plans, but only those up to Rs 1 lakh qualify for tax benefits. Investments made in non-ELSS MFs don’t qualify for tax deduction. The first break comes while investing in ELSS.

Your gross total income is reduced by the amount you invest in the scheme. If you are paying a tax of 30.9 per cent, you can save up to Rs 30,900 on an investment of Rs 1 lakh or more in ELSS, including the surcharge and education cess.

Lower lock-in: Compared to other products in the market, ELSS has a lower lock-in period. Other similar tax-saver like the Public Provident Fund is a 15-year savings plan, while the National Savings Certificates carries a lock-in of six years.

Every investment you make in other products, such as insurance Ulips, are also long-term products. Even investment done through SIPs have a lock-in of only three years.

BENEFITS OF ELSS

The very nature of an ELSS suits an equity investment made for at least three years. The three-year lock-in stipulation might seem harsh, but it has its advantages. By forcing you to take a long-term view, it induces discipline into your investing habits.

You can lock yourself in at low valuations, but also have to give your investment time to work for you. The lock-in keeps corporate money out, which means these schemes don’t have to deal with sudden, large-scale redemptions. As a result, ELSSs tend to have a more stable and optimum corpus size, which encourages good fund management. This gives ELSS fund managers more leeway to plan their portfolios than those of conventional equity funds, who have to contend with unpredictable redemptions (often large-scale ones). No surprise then that most ELSSs are doing better than their open-ended diversified peers.

HOW TO CHOOSE

Before selecting an ELSS, ensure that your investment takes into account your risk profile and the overall asset allocation of your portfolio. These schemes are suitable for investors willing to take a higher risk for better returns from their tax-saving investments. Choose funds with a longer performance history and track record for investments. The longer the performance history, the longer time a fund has to test its mettle in various market situations. It would be easier for the investor too, to evaluate consistency in the fund’s performance. The performance of the fund should be compared with that of its benchmark and peers. An investor should also assess the risk and return strategy of the fund and take a call on whether he is comfortable with it. Fund houses with strong and established processes and those that focus on fund management teams rather than star fund managers are better.

HOW MANY ELSSs TO HOLD

There is no fixed rule. Around 2-4 schemes can be a part of your portfolio depending on your investment amount. It helps you diversify across different fund managers also. Too much of them could be a deterrent as well. Managing and tracking them will be difficult. Besides, there could be overlaps in the stocks they hold, thus reducing the advantage of a concentrated portfolio. Have a look at their individual portfolios to determine the mid-cap or the large-cap focus of the funds and then take a decision.

HOW TO CHECK RETURNS

One of the key things is to measure the performance of your fund periodically. You can compare your ELSS funds to other diversified equity fund in the market on a periodic basis. Websites help you track your investments and returns on a regular basis. You can also calculate the returns yourself by dividing the latest NAV with that at the time of investment. As you also save taxes as per your tax bracket, an investment in an ELSS fund also boosts your net post-tax yield significantly.

HOW TO INVEST

Lump sum or in installments: You may either invest in lump sum or go the systematic investment plan (SIP) way. Identifying the scheme and starting an SIP would ensure that the investor benefits from lower acquisition costs through rupee cost averaging in a volatile market. In vesting periodically also spreads the burden. However, remember that each installment will be subject to a three-year lock-in. So, if you enroll in a one-year SIP and invest systematically every month for three years, you will get your entire proceeds only after four years, after your last installment (at the end of the third year) completes three years.

Growth or dividend option. Once you have decided on the mode lump sum or through SIP – choosing the growth or dividend option is the next step. Choosing the growth option ensures compounding and capital appreciation in a mutual fund investment. However, in case of an ELSS, the dividend payout option provides a degree of liquidity even during the lock-in period. The dividend paid out can be invested in other investment options, whether equity or debt, depending upon the rebalancing needs of the investor’s portfolio and, thereby, reduce the risk in the overall investment plan. From the tax perspective, both options are equally efficient as dividends are tax-free.

OTHER TAX SAVERS

Let’s also look at various other tax-saving investments and measure them in terms of their duration, returns and income flows. The deduction from income of up to Rs 1 lakh in addition to ELSS may also be spread in any of the specified investments like notified bank fixed deposits of five year duration, Senior Citizens Savings Scheme (SCSS), life insurance, Employees’ Provident Fund, Public Provident Fund, National Savings Certificate (NSC) or post office time deposits.

Of these tax-saving instruments, most have the lock-in periods for more than five years. The safety of capital and option to get regular fixed and assured interest would be there. However, three important things that one needs to look at before investing in any of the mentioned fixed income instruments are taxability of interest income, frequency of income and tenure of investment.

Even if the interest rate SCSS is 9 per cent per annum, the interest income is fully taxable. This means that for someone in the highest tax-bracket, the actual return after-tax will be only 6.22 per cent.

Similarly, if your need is a regular monthly income, the instrument with the highest post-tax return, Public Provident Fund, may not be the right choice. Only three of the fixed income instruments that qualify for relief under Section 80C give a regular stream of income. The SCSS pays interest quarterly, five-year notified bank deposits half-yearly, and time deposits annually. Not just the tax, the returns are eaten away by inflation too. The real rate of post-inflation return is generally low in these instruments. So, even though you invest and are assured that your money is safe, inflation keeps bringing down the purchasing power of your money and there is no creation of wealth in the long run. If you like the safety of a steady predictable income, every month, quarter or year, then there are a number of tax-saving instruments available for you. In fact, most of the tax-saving paper you could buy is in this category. For those who are uncomfortable with fluctuating incomes that market-linked instruments give, these are the products for you. Admittedly, returns from fixed-in-come instruments averaging about 8 per cent a year, do not even compare with those from equity-related products, especially ELSS, that have returned over 30 per cent compounded annual growth rate (CAGR) in the last few years. But then, the return from most fixed-income products you get is also market risk-free. At the end of every designated period, you know you will get a certain amount. And that imparts stability to a portfolio. They are suitable for investors who need to cut down on the risk, such as people nearing retirement. For them, these could even form the mainstay of their portfolio.