Does ELSS add value once the tax benefit is exhausted

Does ELSS add value once the tax benefit is exhausted?

An equity-linked savings scheme (ELSS) is an equity fund with a 3-year lock-in. This ELSS fund is unique because investment in it is eligible for tax exemption under Section 80C of the Income Tax Act. Remember, Section 80C is a vast umbrella, and the INR 1.50 lakh exemption limit is the overall limit that includes EPF, PPF, Life Insurance Premiums, Long term bank deposits, ULIPs and ELSS, among others. For young millennials starting their tax planning journey, ELSS can be an excellent way to get tax benefits and long-term wealth creation.

Once the INR 1.50 lakh outer limit for Section 80C is crossed, no further tax benefits are available. But a common question is whether investors should continue to buy ELSS funds even after the Section 80C limit is exhausted.

Let us first understand the impact of Section 80C on ELSS. To answer the impact, let us look at two scenarios. In scenario 1, we examine whether ELSS as a returns product is superior to large-cap and multi-cap equity funds. Let us look at category averages across three asset classes: Large Cap Funds, ELSS funds and Multi-Cap funds. As per Morningstar rankings, over 5 years, average returns would have been 10.74% in large-cap funds, 11.11% in ELSS funds and 13.63% in multi-cap funds. Purely on returns, there is not much to choose between ELSS and large-cap funds, while multi-cap funds seem to have a clear performance edge.

How much does the tax benefit make a difference? In fact, that is where the ELSS funds score over other categories. Here is how the tax benefit works. Let us assume you are eligible for the complete Rs1.50 lakh exemption under Section 80C. If you are in the 20% tax bracket, you get a 20% exemption on your ELSS investment. In other words, You would be investing 20% less than what you invested. In the above case, due to the 20% tax break, your ELSS returns are enhanced from 11.11% to 13.89%. In other words, the actual edge for ELSS comes from the tax break.

That said, there are some other advantages that ELSS offers. Firstly, it is an excellent way to onboard first-time investors to the equity bandwagon. Secondly, unlike traditional debt products like 5-year band deposits, returns on ELSS can be higher and wealth accretive. In terms of tax implications, ELSS held for a long term is taxed at 10% of gains above Rs1 lakh per year, which makes it more tax efficient than most other Section 80C products.

Should you invest in ELSS beyond the 80C limit?

At the outset, nothing is stopping you from investing beyond the Section 80C limit of INR 1.50 lakh. It is unlike PPF, where investors cannot invest above that limit. There are no such restrictions on ELSS. However, an investor must remember that the entire amount you invest in an ELSS fund would be subjected to the 3-year mandatory lock-in period, irrespective of whether you get the Section 80C benefit or not.

There are 3 things you must consider while investing in ELSS beyond the Section 80C limit.

Does it make sense to lock in your funds for 3 years, even after Section 80C has been exhausted? If you look at the returns, the answer would be an emphatic “No”. Without the tax benefit, the ELSS returns, on an average, are almost at par with large cap funds and much lower than multi-cap funds. There is no real commensurate benefit of locking in your funds for three years, once the limit is exhausted under Section 80C. You must also look at your ELSS exposure from an asset allocation standpoint. Your financial plan typically has a specific allocation to equity, debt, gold and liquid assets. Adding ELSS funds beyond a point enhances your equity exposure. If the markets appreciate and equity allocation goes up, then your ability to reallocate from equity to debt is constrained due to the lock-in stipulation. That is a practical challenge. One justification for investing in ELSS is that the lock-in period allows fund managers to take a long-term view without worrying about cash liquidity and short-term fluctuations. However, that does not reflect in the returns over five years.

The broad takeaway is that much of the advantage in an ELSS fund stems from the tax benefits proffered by Section 80C of the Income Tax Act. Bereft of that benefit, there is not much to choose between a large cap fund and an ELSS. In that case, the 3-year lock-in may be a steep price.Get the most out of your investments with mutual funds. With a wide range of fund options and expert guidance, Invest Wisely will help you understand the risks and rewards associated with investing in mutual funds, so you can maximize your returns