Equity Linked Savings Schemes: High returns + tax savings (Part I)

As the time to file tax returns draws closer, it’s prudent to explore various ways one can save tax. One such avenue is ELSS or Equity Linked Savings Schemes.

In the midst of tax season, thousands of us get e-mails from our employers asking us to produce proofs qualifying investments made under Section 80C, so that we may avail tax deductions.

This sends most of us in a tizzy and we start investing in the first thing we can get our hands on. Please don’t do that.

There are far too many people who think this is a good idea, and end up losing money and precious time. Instead, let’s look at one of the smartest investment instruments available in the market in a two-part series: ELSS investment.

What is ELSS fund?

An Equity Linked Savings Scheme (ELSS) is an open-ended Equity Mutual Fund that not only helps you save tax, but also gives you an opportunity to grow your money. It qualifies for tax exemptions under section 80C of the Indian Income Tax Act, 1961.

How ELSS works?

The following are some of the features of an ELSS:

• ELSS is a type of diversified equity mutual fund that invests across sectors
• ELSS is an open-ended mutual fund which means that it does not have restrictions on the amount of shares the fund will issue
• There is a mandate to keep at least 65% of the total funds invested into equity at all times
• ELSS qualifies as a permitted tax saving instrument under Section 80C of the Income Tax Act. You can claim a tax deduction on investment up to Rs. 1.50 lakhs in a financial year.
• There is a lock-in period of 3 years from the date of investment in the scheme. So if you’re investing through systematic investment plan (SIP) mode, every SIP will be subject to a separate 3-year lock-in.
• Like most equity funds, ELSS funds have both growth and dividend options. With Growth schemes, you get a lump sum pay-out after the lock-in period of 3 years. With Dividend schemes, you get a regular income during the lock-in period, whenever dividend is declared. 
• Is ELSS taxable? Both returns- capital appreciation and dividend- earned on an ELSS scheme are tax-free
• Since 2009, the entry load is not applicable across mutual funds. These schemes are also not subject to an exit load.

Related: ULIPs vs Mutual Funds- Where to invest?

Is ELSS investment a good choice?

When we speak of investment avenues under Section 80C, one generally comes across fixed income options like PPF, NSC, 5-year bank FD, etc. However, ELSS scores better in the following ways:

• ELSS has the least lock-in period as compared to other avenues. So, where PPF and bank FD comes with a fifteen and five-year lock-in, a lower three-year lock-in in case of ELSS is very comforting to investors as it provides greater liquidity.
• ELSS invests predominantly in equity. Equity as an asset class has rewarded investors the most and has also beaten inflation handsomely. If we see the 10-year returns from ELSS category, it stands at 12.69% which beats the 8-9% available under the fixed income options, by a considerable margin.
• ELSS funds fall under the exempt-exempt-exempt (EEE) category. This means that tax deduction on ELSS is three-pronged:

1. Investments in ELSS funds exempt from Tax Deduction under sec 80C
2. Capital gains generated by the fund are also exempt as investments are not withdrawn
3. Withdrawals are also exempt as there is no tax payable on capital earns generated from equity-oriented mutual funds

• With other open-ended schemes, fund managers are sometimes wary of investing in funds even if they promise high returns because there is the risk that investors can withdraw anytime. Thus, the lock-in that comes with an ELSS is actually a blessing as it helps a fund manager to take high conviction bets knowing that the funds are for the long term. This goes a long way towards helping earn better returns as compared to other open-ended schemes.

Related: Simply ways to diversify your financial portfolio

Having said that, since Equity Linked Savings Schemes have a substantial allocation towards equity, the returns from these schemes will carry short-term fluctuations. Hence, you should keep in mind your risk profile and financial goals before taking an investment decision. Instead of planning to withdraw funds after 3-year lock-in is over, you must be willing to stay invested for a minimum time horizon of 7-10 years to get the highest returns possible. If you cannot do so or find that you need the money before that time, it is advisable to skip ELSS investment and consider other available fixed income options. If you’re not sure, you should consult a financial planner who can guide you properly.

Related: Investment options- thinking beyond the obvious

To know the best available ELSS funds available and how to invest in ELSS, stay tuned for Part 2 in this series. If you have any specific questions, feel free to leave them below.