5 mins read . 27 Jan 2023
Equity-linked savings schemes (ELSS) are an extension of equity funds. The only difference is that they come with tax exemption under Section 80C of the Income Tax Act subject to the current ceiling of Rs1.50 lakhs per fiscal year. However, to be eligible to enjoy this tax benefit, the investor must hold the ELSS fund for a minimum period of 3 years from the date of purchase. That is the lock-in period. This lock-in period is calculated from the date of investment, and this rule applies even if you do SIP on an ELSS fund. Why is ELSS fast emerging as the preferred tax-saving choice for investors?
There are several reasons why they have become preferred. Firstly, being equity funds, a big chunk of their portfolio is in equities. They become natural long term wealth creators. The ELSS has a mandatory lock-in for every investor so the churn is much lower and therefore fund managers have the luxury of taking a much longer-term view. ELSS has the lowest lock-in period among tax saving instruments of just 3 years, making it special.
That is the word; young people are veering towards ELSS as a default entry point to save taxes. It does happen that when young people start out on their careers, they are quite wary of investing in equities. It is not just about the uncertainties involved but also because most people are not well informed about the pros and cons of equity investing. The advantage with an ELSS is that it becomes a part of the tax saving routine. In addition, the 3 year mandatory lock in period almost impels investors to take a long term approach to equity investing. The unique feature of equities is that it has the best risk adjusted returns in the long run. That explains why ELSS is becoming a great on-boarding tool for investors.
The real benefit that ELSS offers can only be understood on a post-tax basis and for that you need to grasp how the tax exemption works to the advantage of the investor. The table below captures this methodology. We compare equity fund with an ELSS fund, which are similar in all other ways.
|Investor A (Equity Fund)|
Investor B ( ELSS Fund)
|Investment amount||Rs100,000||Investment amount||Rs100,000|
|Value at the end of 3 years||Rs175,000||Value at the end of 3 years||Rs175,000|
|Profit in INR||Rs75,000||Profit in INR||Rs75,000|
|Total Returns over 3 years||75%||Total Returns over 3 years||75%|
|CAGR Returns||20.6%||CAGR Returns||20.6%|
|Effective Returns after considering Section 80C benefits|
|Exemption u/s 80C||-||Exemption u/s 80C||Rs30,000|
|Effective Investment in T1||Rs100,000||Effective Investment in T1||Rs70,000|
|Effective CAGR Returns||20.6%||Effective CAGR Returns||35.8%|
|Note: For simplicity, we ignored the impact of surcharge and cess on tax|
Since the tax break is available at the end of the same year, the effective investment in the ELSS reduces to the extent of the tax break. As the table above suggests, the smaller effective principal investment makes all the difference to an ELSS fund.
It is also possible to invest in ELSS in a phased manner via SIPs. Obviously, each SIP instalment of SIP gets locked in for 3 years from the SIP date. However, combining ELSS and SIP is like hitting 3 birds with 1 stone. Here is why. Firstly, it helps you match your outflows with your inflows and encourages you to start planning taxes early. That is always a good idea rather than getting into rush hour. Secondly, ELSS via SIP gives the added benefit of rupee costing averaging (RCA). This automatically lowers the average cost of buying and enhances the ROI. Lastly, taxes cannot be avoided so it has to be planned. ELSS in SIP mode makes equity investing a discipline at an early stage.