ELSS -A key for tax saving and long term financial planning

Most salaried tax payers awaken to tax planning only in December when the accounts department at office rings the alarm bell for proof of tax saving investments. A few calls / visits to tax planners, insurance agents and postal savings agents later, the immediate objective of investments and proof submission is met. However, no attempt is made to understand the tax planning process thoroughly. As such, individuals end up investing in avenues which may not necessarily map out their long-term financial goals. At that point, saving tax is the objective and not investment.

An analysis by CRISIL suggests that it is possible to do both tax planning and long term financial planning together. Further, if one is willing to take some risks, Equity Linked Savings Schemes (ELSS) offered by mutual funds provides an opportunity to generate attractive long term returns, if invested for longer period (more than 5 years).

What are Equity Linked Saving Schemes?

ELSS are tax saving schemes offered by mutual funds that predominantly invest in a diversified portfolio of stocks. There are 48 schemes of this category available in the domestic mutual fund space. One needs to hold the units for a minimum period of three years to claim tax rebate. This serves well for the fund manager in terms of a lower portfolio churn, which in turn brings down transaction costs.

ELSS have the lowest lock-in period of three years among all tax saving instruments available under section 80C. It also allows small-amount investments, as low as Rs 500, at regular intervals through Systematic Investment Plans (SIP), thereby helping investors benefit from disciplined long-term investing. Investments in ELSS are, however, subject to market risk and must be made taking into consideration age and risk taking ability. The investment horizon should be more than five years for higher risk adjusted returns.

Tax Saving Options

Ideally, one must follow a comprehensive financial planning model which includes tax planning along with risk profiling, goal setting and asset allocation. This not only lends a long-term perspective to tax saving investments but also indulges in a disciplined approach to tax planning. Importantly, tax planning should be a yearlong exercise and not a blink-of-an-eye moment. It helps in planning the monetary outflows for the entire year instead of making lump sum contributions at year-end. It also gives investors adequate time to understand and evaluate different investment options.

Section	Investment / Deduction Limit	Investment options
80 C	Rs 1,00,000	i) Equity Linked Saving Schemes (ELSS) offered by mutual funds
		ii) Unit Linked Insurance Plans (ULIPs) offered by insurance companies
		iii) Traditional - Public Provident Fund (PPF),National Savings Certificate (NSC), 5-year Bank Fixed Deposits (FDs), premium paid towards traditional life insurance plans, pension plans like National Pension System (NPS), Employee Provident Fund (EPF)
		iv) Housing loan - repayment of house loan principal
		v) Children tuition fees
80 CCF	Rs 20,000	Infrastructure bonds
80E, 80D,80DD, 80DDB	Every section has a individual investment limit as per the Income Tax Act	Interest repayment on education loan, mediclaim policy premium, totally blind / physically disabled employee, expenses on treatment of handicapped dependants
Section 24	Rs 1,50,000	Housing loan - interest payment

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A part of tax saving corpus can be diverted to equity instruments

Investors generally prefer traditional debt instruments for tax saving. While these may provide safety and stability, they fall short of generating higher inflation adjusted returns over the long run.

For example, instruments earning 9% rate of interest when average inflation is around 9% will yield 0% real rate of return. Hence, investors willing to take some amount of market risk may look at equity linked investments via mutual funds for the long term. This asset class has historically provided high returns over longer periods. The S&P CNX Nifty has returned over 16% in the 10-year period ended December 30, 2011, almost double compared with around 8-10% yielded by tax saving debt instruments. Among equity tax saving instruments, ELSS, ULIPs and the equity option of the NPS are available for investment. The lock-in period for ELSS is three years, for ULIPs, it is five years, and NPS, has a lock-in period till 60 years of age.

Table 1 - Performance of ELSS

Category/ Index	3 Years Returns %	5 Years Returns %	7 Years Returns %	10 Years Returns %
ELSS Category Average*	17.92	2.56	11.91	22.28
Maximum returns in the category	26.28	11.77	17.73	28.25
Minimum returns in the category	6.13	-3.44	5.16	13.47
SIP Returns of CRISIL Fund Rank 1ELSS Scheme*	7.41	7.61	10.56	19.57
S&P CNX 500 (Benchmark for ELSS schemes)	16.01	1.77	10.56	18.06
Returns from PPF investment	8.02	8.01	8.01	8.13
Returns from investment in NSC^	8.16	8.16	8.16	9.1
Average Inflation rate	7.57	6.8	6.4	5.8

 

 

 

 

 

 

 

 

 

 

 

 

Data as on December 30, 2011
All returns are annualised
* Category average of all CRISIL Fund Rank ELSS as of December 2011 quarter
** Rs 10,000 invested every month in a CRISIL Fund Rank 1 ELSS Scheme
^ Semi annualized returns, assumed that a 6-year NSC is rolled over at the prevailing rates for calculating 7-year and 10-year returns

 

Performance

As indicated in Table 1, ELSS beat the benchmark (S&P CNX 500) in all the periods analysed. Additionally, these funds have also provided positive inflation adjusted returns across 3 of the 4 periods analysed. This gives us a fair idea of the benefits of investing in ELSS to generate higher returns in the long term in addition to saving tax.

How to choose ELSS?

Since ELSS have a lock-in period of three years, it is important to choose wisely; a poor decision means there is no immediate way out. Look out for funds with proven track record in good as well bad times, experienced fund managers, fund houses with good investment management practices and client servicing capabilities. (Click here to know the top ranked ELSS by CRISIL.)

Proposed new Direct Tax Code (DTC)

In the first draft of the DTC released last year, the government had stated that fresh investments in ELSS post April 1, 2012 would not be eligible for tax benefits. However, the DTC bill is yet to be passed in Parliament. Till such time, investments in ELSS would be eligible for tax benefits. However, once the rule changes, investors are advised to read the final DTC fine print before deciding on tax planning avenues.