How to benefit from investments in tax saving mutual funds
Apart from creating wealth over the long term, there is also an important tax benefit that you get when you invest in an ELSS.
Equity linked savings schemes (ELSS) are simple diversified equity mutual fund schemes. The only difference is that, since they offer a tax break for the investor, they entail a lock-in period of three years. Typically, ELSS funds have tended to outperform the index over the longer term horizon for a few basic reasons.
The lock-in period enforces buy-and-hold discipline in the investor.
When it comes to equity and equity products, it is time that matters more than timing. Normally, if you hold on to good stocks and good mutual funds over a longer period of time, you are likely to earn higher returns. Since ELSS has a compulsory lock-in period of three years, the investor is required to hold it for three years by default. Many investors do have the tendency to book profits in mutual funds on every rise in NAV. That tendency will be eschewed in ELSS.
Lock-in also instills discipline in the fund manager…
Just as the investor needs to take a long-term perspective, the fund manager also needs to take a long-term perspective. Since the fund manager is aware that the ELSS comes with a minimum lock-in of three years, they do not worry about redemption pressure. As a result, the fund manager is able to reduce the churn in the portfolio, benefiting the mutual fund holder with a long term perspective as well as lower transaction costs.
There is also a very strong tax efficiency angle to it.
Apart from creating wealth over the long term, there is also an important tax benefit that you get when you invest in an ELSS. There is a tax exemption under Section 80C of the Income Tax Act which offers an exemption to the extent of Rs.150,000 per annum on ELSS investments. Of course, the ELSS gets clubbed with a variety of other items like insurance premiums, PF contribution, long term bank FDs, tuition fees etc. The interesting point is that this tax break actually helps to improve your effective yield on the ELSS. Here is how it works…
Let us assume that you invested Rs.100,000 in a mutual fund ELSS. You get a 30% exemption (for simplicity we will assume the tax rate to be 30%), which amounts to Rs.30,000. At the end of three years, if the NAV of the fund grows from Rs.10 to Rs.14, then the value of your Rs. 1 lakh investment will have grown to Rs.140,000. If you are disappointed with just a 40% return in 3 years, think again! When you invested Rs.100,000, you got a tax break of Rs.30,000. That means, you effectively invested only Rs.70,000. This Rs.70,000 investment has grown to Rs.140,000; meaning your investment has given 100% return and doubled in 3 years. That is how important the tax break in ELSS is for investors like you.
Even though it is an ELSS, play it smart through the SIP route.
A systematic investment plan (SIP) is a phased approach to investing. That means, each month when you get your salary, you invest a small amount in an ELSS. There are three distinct advantages in this SIP- approach to ELSS buying:
• Tax planning becomes more of a planned affair for you rather than trying to bunch all your tax-related investments in the last quarter. This not only inculcates saving discipline but also saves you the funding blushes in the last quarter.
• You obviously get the added benefit of rupee-cost averaging by opting for a SIP. That means when the NAV goes down you buy more units and when the NAV goes up you get a better yield. Over the longer term, this approach tends to be more productive for you.
• SIP on ELSS helps you create liquidity on your ELSS on a rolling basis. For example, if you start your ELSS SIP in April 2017, then that installment matures in April 2020. However, if you bunch all your ELSS investments in March 2018, then you have to wait till March 2021 to liquidate your ELSS investment.
Remember, ELSS investing is not just about saving your taxes via Section 80C. While the tax break is critical, it is the lock-in period that enforces discipline on the investor and the fund-manager. Of course, do not forget to adopt the SIP approach while investing in ELSS. That gives you a combination of stable returns, tax efficiency and rupee cost averaging. Surely, a winning combination!The writer is founder of Right Horizons.