Why Elss Funds Are A Great Way To Create Wealth And Save Tax

ELSS funds or tax saving funds are nothing but equity funds with a mandatory 3 year lock-in. Investors can invest in an ELSS fund either in a lump sum or as a SIP. Either ways, the investment in ELSS up to Rs.150,000 crore outer limit is eligible for tax exemption under Section 80C of the Income Tax Act.

Is it true that elss funds earn good returns?

That would largely depend on what you compare with. However, let us understand 3 very important that work to the advantage of the ELSS Funds.

  1. ELSS funds get tax exemption on the investing under Section 80C. Hence, up to the limit, the exemption reduces the effective cost of investment and enhances ROI.
  2. Secondly, ELSS is the only pure equity tax saving scheme and the 3-year lock-in automatically works to the advantage as equity returns build over time.
  3. Lastly, if you compare with other tax saving instruments, ELSS has the lowest lock-in period of 3 years compared to 5 years for ULIPs and 15 years for PPF.

All these factors work to the advantage of ELSS and ensure healthy returns to the investors.

Can you explain with an example, how the tax benefit of ELSS improves ROI?

Here we compare two funds over a period of 3 years. Both are equity-based funds with similar portfolios. Hence, the performance of the fund over a 3-year period between 2018 and 2021 has been the same. Now we will use a tabular analysis to understand how the ELSS fund still ends up with a higher ROI due to the tax benefit available.

For simplicity we assume that both the funds perform exactly the same in terms of NAV movement, both are held for 3 years and the tax bracket for the investor is 30%. Here is how the comparison looks like

Variables Equity Fund Variables ELSS Fund
NAV on Nov 1, 2018 Rs.20.00 NAV on Nov 1, 2018 Rs.20.00
NAV on Oct 30, 2021 Rs.35.00 NAV on Oct 30, 2021 Rs.35.00
NAV Appreciation Rs.15.00 NAV Appreciation Rs.15.00
Percentage Returns 75% Percentage Returns 75%
Tax Rebate Sec 80C Nil Tax Rebate Sec 80C 30%
Effective Investment N.A Effective Investment Rs.14
Effective 3-year returns N.A Effective 3-year returns 150%
Effective CAGR return 20.50% Effective CAGR Return 35.80%

The above table is quite self-explicit. Here are 5 things you can infer from the above tabular comparison of the two funds.

  • Difference between a normal equity fund and an ELSS fund comes due to the tax rebate under Section 80C available to an ELSS.
  • For simplicity we have considered rebate at 30% of the peak tax rate. Normally, higher the applicable tax rate, higher the ROI for the investor.
  • We have reduce the effective cost of acquisition by the amount of tax rebate, which is what enhances the ROI on the ELSS fund.
  • The advantage of the ELSS is that the tax benefit can be rolled over every years and this outperformance can be repeated.
  • The above calculation will not work in case the Section 80C benefit has already been exhausted by other schemes like LIC, PPF, home loan principal, ULIPs etc.

What are the 5 things that investors must know about ELSS funds?

Here are five important things that investors must necessarily know about ELSS Funds.

  • An ELSS is like any other equity fund in terms of portfolio composition and this benefit is not available to debt fund investments.
  • ELSS investments entail a compulsory lock in period of 3 years from the date of investment.
  • ELSS can be done via lump sum or SIP as long as it is in the financial year. In both cases, the lock in applies from respective date of purchase.
  • The attraction of the ELSS fund is that they offer a tax rebate under Section 80C of the Income Tax Act up to the overall limit of Rs.150,000.
  • Most ELSS funds have either performed at par with equity diversified funds or below these funds but rarely have they outperformed on pure return basis.

Is it true that ELSS funds are one of the best tax planning tools?

Over the years, the popularity of ELSS funds has grown substantially. ELSS funds have become a major focus area for investors looking to save tax. Here are 5 reasons for the same.

  • ELSS based tax-saving equity fund tends give phenomenally higher effective returns compared to regular equity funds due to the tax rebate which could be at the rate of 20% or 30% as the case maybe. ELSS investment reduces effective investment in the first year itself. This enhances effective total return over 3 years although fund performance is the same.
  • ELSS funds tend to do well due to the implicit lock-in requirement in an ELSS fund. As a result of the lock-in, the liquidity requirements in an ELSS fund are much lower and fund managers are able to take a longer-term view on markets. This results in a more long-term perspective from fund managers.
  • Tax benefit of ELSS funds can be rolled over every 3 years. At the end of 3 years, you can redeem the ELSS and then reinvest the proceeds in an ELSS fund. In the fourth year you again get Section 80C benefits. Unlike PF and Insurance, the shorter lock in period makes it a much better instrument to churn money efficiently.
  • ELSS inculcates the equity cult in investors at an early stage. The truth about equities is that the earlier you start the more your wealth grows and the risk actually works hard in your favor. Equities are your best bet to create wealth in the long run and this is all the truer in the case of an ELSS fund.
  • An ELSS fund can also be structured as an SIP on an ELSS. That way you are aligning your outflows with your inflows and at the same time creating wealth with the benefit of tax breaks. The point to remember here is that each SIP installment will have a 3-year lock in from the date of the SIP.

To sum it up, ELSS fund investing is like hitting 3 birds with one stone. It creates wealth through equities; it offers return enhancing tax breaks and above all it inculcates the discipline of investing early on. That is something that positions ELSS funds as a unique tax saving cum wealth creation too, especially for the young investors who are starting out on their career paths.

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