Tax-efficiency is a simple matter of keeping tax costs to a minimum, which, incidentally, is also a key aspect of achieving superior long-term returns. Because when you keep more of your money, you are enabled to build wealth more effectively.
In 3 smart tax-planning moves, we wrote about taking a holistic approach to investing. And why the consequences of tax-saving products should be considered in the entire portfolio construct.
Here we will look at the basics of ELSS.
The product
An ELSS is an acronym for Equity Linked Savings Scheme, which is a diversified equity mutual fund.
This implies various features:
This is an equity fund which means that a minimum of 65% of the fund’s assets will be invested in the stock market.
Unlike a thematic fund (such as pharma or banking) or a sector fund (such as auto or FMCG), this is a diversified fund that will invest across sectors and industries.
The fund manager will decide predominantly which market cap to invest in. Depending on whether he focuses on large stocks or smaller fare, the fund will take a large-cap tilt or a mid-cap tilt. It could also be a flexi-cap fund if the complexion of the market cap exposure keeps changing.
The tax benefit
An ELSS has an equity exposure but also provides a tax benefit under Section 80C of the Income Tax Act. Under this section, designated investments are eligible for a tax deduction.
There is no maximum investment limit to your investment in the ELSS, however, only amounts up to Rs 1.50 lakh are eligible for a tax break. Having said that, bear in mind that this limit also encompasses other investments and deductions.
As with any equity investment, it has the potential for wealth creation. Combined with the tax break, it makes for an excellent investment. However, exercise caution. You need to choose your fund wisely as there are numerous options available in the market and not all good.
The lock-in period
All tax-saving investments have a lock-in period. The Public Provident Fund (PPF) has the longest lock-in period of 15 years, while National Savings Certificate (NSC) is much shorter at 5 years. (Read PPF vs NSC)
In the case of ELSS, it is 36 months or 3 years. You cannot sell your units before the completion of this period.
If you do a Systematic Investment Plan (SIP), it will be 3 years from the date of investment. Basically, every instalment will have a 3-year lock-in commencing from the date of that specific instalment. After the lock-in period, you can access your money any time since it is an open-ended fund. So, for the SIP done on, say, March 1, 2018, the lock-in period will be 3 years starting from March. For the instalment made on December 1, 2018, the lock-in period will commence for 3 years from then.
The combination of equity and tax saving
An ELSS helps investors save on tax, and a good ELSS will help them further in wealth creation by beating inflation.
Whether it ebbs or gallops, inflation will always be present. Ensure that your investment beats inflation by a substantial margin. A grouse against ELSS is that the returns are not guaranteed. That is no doubt true, but the returns in ELSS are higher than fixed-return instruments; the 3-year annualized category average was 14.45% as on December 31, 2017. In the case of instruments like NSC, not only does it have the task of beating inflation, but the tax impact on interest earned makes it lose its edge. However, do note that according to the latest Union Budget, investors in equity mutual funds will have to pay a long-term capital gain (LTCG) tax of 10%, if the long-term capital gains for that financial year are above Rs 1 lakh.
If investors avoid equity, they could face a major shortfall risk. This is the risk that an investment’s actual return (post inflation and taxes) will not be sufficient to generate the money needed to meet one’s investment goals.
If investors invested all their money in fixed return investments, there is a very high probability that they would certainly not save sufficiently for goals such as retirement or child’s education.
Moreover, we have seen interest rates fall over the years. Tax-saving instruments have not been spared. PPF is a prime example. From 12% p.a. it began descending to now stand at 7.6%. Such instruments offer the assurance of fixed returns, but do little to help in wealth creation. (Read 5 questions on PPF answered).
That is why equity is so crucial in an investor’s portfolio because good equity investments over the long term do provide returns which outpace inflation and assist in wealth creation.
Our next post will look at how to select an ELSS.
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