Thinking of Investing in Best Tax Saving Mutual Funds? here's A Detailed Guide

An Equity Linked Saving Scheme (ELSS) is an equity mutual fund with a tax benefit on investment. The taxation of the dividends and the capital gains will remain the same as in other cases? When we talk of tax benefits here we need to understand the tax benefit as distinct from the tax benefits on dividend and capital gains.

An ELSS Fund scores over other equity funds is in the special tax exemption under Section 80C. If you invest say Rs.80,000 per year in ELSS schemes, then this Rs.80,000 can be directly deducted from your taxable income and so you taxable income reduces to that extent. This reduces your tax liability, which is what makes ELSS funds or tax saving funds attractive.

So, if I invest in ELSS, that sum is reduced from my taxable income?

Yes, but only up to a certain limit. Section 80C is a special exemption given to tax payers up to a limit of Rs.150,000 per annum. However, there is one more catch here. ELSS is just one of the many assets that qualify for Section 80C. In short, 80C benefits are conferred on a lot of items like the LIC premium, contribution to provident fund, payment of tuition fees for your children, principal repayment on your home loan and long term bank FDs among other things. In addition, Section 80C also includes Equity Linked Savings Scheme (ELSS).

Now this ELSS fund is like any other equity mutual fund with the only difference being that there is a compulsory lock-in of 3 years from the date of the investment. These units cannot be redeemed before the completion of 3 years and in case you do it then you lose the tax benefit in the next assessment year. ELSS is also included under Section 80C and the exemption limit of Rs.150,000 is applicable to all the items mentioned above combined. What is important is that Section 80C tax exemption substantially enhances the effective post-tax yield on an ELSS fund.

How exactly does tax benefit enhance the return for investors?

Let us put it this way. When you invest in an ELSS fund, you get tax exemption. In other words, this reduces the amount of actual investment that you made. Let us understand with an illustration. Here are 2 funds, Fund A and Fund B which have behaved exactly same, with exactly returns. The only difference is that Fund A is an equity fund while Fund B is an ELSS fund.

Fund A (Equity Fund) Amount Fund B ( ELSS Fund) Amount
Investment amount 100,000 Investment amount 100,000
Value at the end of 3 years 175,000 Value at the end of 3 years 175,000
Profit in INR 75,000 Profit in INR 75,000
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 30,000
Effective Investment in T1 100,000 Effective Investment in T1 70,000
Revised CAGR Returns after considering Section 80C 20.6% Revised CAGR Returns after considering Section 80C 35.8%

This is an extremely interesting analysis. The table captures the huge difference that the Section 80C rebate offers to Fund B by substantially enhancing returns. Let us assume that the investor gets 30% tax rebate in the year of investment which effectively reduces outlay to Rs.70,000. This makes a massive difference to the CAGR returns over 3 years, although both the funds have performed similarly. You earn the same return on a much smaller upfront investment. It is this aspect that enhances return on investment and makes a big difference to the returns.

Do ELSS funds perform better than equity funds?

Due to the tax break, the yield on an ELSS fund will be generally higher than an equity funds. There is also an argument that ELSS not only saves tax but also forces you take a long term view of investing. This is due to the compulsory 3-year lock-in. As a result, the fund managers in equity funds do not need to churn frequently or keep cash available. That should have normally worked in favour of the ELSS funds. But is that the case.

Interestingly, there is no empirical evidence that proves that other than the tax break, there is any outperformance from the ELSS Funds. They are at par with regular funds or at times even perform worse than regular equity funds. Hence if you have exhausted your Section 80C limits, you can prefer equity funds over ELSS funds as there is no lock-in risk for you. Can you hold on the ELSS after completing 3 years? The choice is yours depending on how the fund has performed. Once 3 years lock-in is over, it is just any other equity fund and offers the same degree of liquidity.

Can an investor do an SIP in ELSS Funds and still get tax benefits?

This is an interesting question and let us understand five very important things here.

  • Firstly, you can absolutely do ELSS buying via SIPs. The Income Tax rules only look at the total investment in ELSS funds during the financial year. It is indifferent whether it lump sum or by SIP.
  • In fact, it is recommended that even an ELSS should be done through the SIP route. The reason is quite practical. It helps you to match your outflows with your inflows and forces you to start planning taxes in a systematic manner.
  • It is about disciplined tax planning. Why wait till the last moment to plan your taxes. Instead, just do an SIP on an ELSS Fund and your tax corpus automatically gets built up through the year without any year end running around.
  • Don’t forget that the benefit of rupee cost averaging or RCA is available in SIPs on ELSS also. This implies that you get better value when the NAV goes up and you get more units when the NAV goes down.
  • Finally, there is one more advantage of adopting SIP route for ELSS. Your 3-year lock in commences from the date investment. Hence an ELSS SIP is better than bunching your ELSS investment at the end of the year, as your ELSS gets freed up earlier.
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