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