When it comes to saving taxes, it’s the Section 80C basket of the Income-tax Act, 1961, that investors focus on as it provides a large deduction of Rs 1.5 lakh per annum and has the biggest bouquet of products. Out of the few equity-oriented products that the 80C basket contains is the equity-linked savings scheme (ELSS) from mutual funds (MFs).
The fact that ELSS comes with a lower lock-in period compared to most other tax-saving products and provides a pure stock market play makes it an attractive option for long-term goals, especially for young investors.
ELSS is a diversified equity scheme that invests across all sectors and market capitalisations as per the scheme objectives. Through ELSS, investors can access the equity market and save on taxes at a reasonable cost.
“ELSS is one of the ideal investment options to save tax. It can work effectively for those who have limited monthly investible surplus and want to save tax,” says Harshad Chetanwala, co-founder, MyWealthGrowth.
The challenge lies in understanding the behaviour of equity markets over a long period of time, which is not a year or even three years, but a decade or even more. With some volatility, equity as an asset class has delivered the best returns in the long run.
If you look at the long-term performance of equity funds over, say, 10 or 15 years, they have delivered superior returns. “ELSS has the potential to offer better returns compared to other tax-free investment options over a long-term horizon. The relatively lower lock-in of three years, compared to other options with a lock-in of five years or more, also offers flexibility,” says Prashant Joshi, co-founder and partner, Fintrust Advisors.
ELSS could be a good starting point for beginners in equity investing. “For those who are at the beginning of their career, ELSS can work as equity diversified MFs as well,” says Chetanwala.
Superior Long-Term Performance
In the last 10 years, the average returns from ELSS funds have been superior to that of large-cap funds, their closest peers—16.78 per cent versus 14.80 per cent (as on December 20, 2021). In the last one year, too, ELSS as a category has outperformed the large-cap category.
It is imperative to compare ELSS with large-cap funds because they invest mostly in large-cap companies. “ELSS funds predominantly invest, say, 70-80 per cent of their portfolio, in large-cap companies, considering that retail investors invest in them,” says Himanshu Shrivastava, associate director, Morningstar Advisors. The regulatory binding for these funds is simply to keep 80 per cent in equity.
Lowest Lock-In Period
ELSS comes with a lock-in period of three years from the date of investment, which is among the lowest among tax-saving products. As it is advisable to have a longer horizon when investing in equities, the lock-in period is useful, especially for those who are new to equity and may not have the financial discipline to stay invested for long. You can hold for longer (than the three-year lock-in) too.
Investing through systematic investment plans (SIPs) is possible but each instalment will be locked for three years from the date of investment.
If you want more liquidity, you may choose the Income Distribution cum Capital Withdrawal (IDCW) option, previously known as the dividend option. You will receive dividends during the three-year lock-in tenure as well, as and when the schemes declare dividends. As per rules, dividends can be given only from booked profits.
Lower Taxation On Returns
Since April 1, 2018, equity fund investors have to pay 10 per cent long-term capital gains (LTCG) tax on profit above Rs 1 lakh per annum. This means the gains made on ELSS investments will attract LTCG tax at redemption if the net gains from equity and equity MFs cross Rs 1 lakh in a financial year.
For those in the higher tax brackets, LTCG rate is much lower (than the income tax rate) with ELSS. Some of the other tax-saving options, however, either give tax-free returns or add the returns to the income of the investor.
What Should You Do?
If you have high risk appetite, you may consider ELSS. However, before investing, do research on the long-term performance of the scheme, expense ratio, fund manager’s strategy, and the pedigree of the fund house. All this becomes important because unlike open-ended diversified equity funds, where you can exit or switch to other schemes, ELSS does not allow premature exit. So, invest in a fund with superior long-term track record.