ELSS or PPF: Which is the better tax-saving investment option?

While ELSS funds deliver better returns over the long term, PPF investments have a tax advantage

February 25, 2021 / 09:20 AM IST

With the financial year 2020-21 drawing to a close in little over a month, many taxpayers indulge in last-minute investments for reducing their tax liability. Amidst this rush, equity linked savings schemes (ELSS) and public provident fund (PPF) are  among the most preferred tax-saving options.

As PPF and ELSS differ widely in terms of asset class exposure, a comparison of their product features would help investors make an informed choice.

Risk

PPF is one of the safest tax-saving investment options. Being managed by the Government of India, both the principal and the interest component of PPF come with sovereign-backed guarantee.

As ELSS funds primarily invest your money in shares, they are prone to the inherent volatility of equity markets. However, this risk can be mitigated by investing in ELSS through the SIP mode. SIPs ensure regular investments at periodical intervals, which help in cost averaging during market corrections and, thereby, eliminate the need for market timing.

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Also read: Why tax-saving MFs can't be ignored despite their poor returns in recent years

Returns

The interest rates of PPF do not remain fixed through its entire tenure. The Finance Ministry reviews interest rates of PPF along with other small saving schemes every financial quarter. The interest rates are set primarily on the basis of government bond yields. Currently, PPF pays 7.1 percent a year on its investments, compounded annually. As its interest income and maturity proceeds are totally tax-free, its post-tax returns are among best when compared to other fixed-income tax-saving instruments.

On the other hand, the returns generated by ELSS schemes depend on the performance of their portfolio constituents. However, being equity-oriented schemes, ELSS funds beat fixed income instruments in the long term by a wide margin. ELSS as a category generated annualized average returns of around 9 percent, 16 percent and 13 percent p.a. over the last three-year, five-year and 10-year periods, respectively.

 Also read: Explained: Some common misconceptions about tax-saving mutual funds

Tax Benefits

Investments in both PPF and ELSS of up to Rs 1.5 lakh per financial year qualify for tax deduction under Section 80C. However, PPF has an edge over ELSS in terms of taxation of returns.

While the interest earned from PPF is completely tax free,  long term capital gains (LTCG) exceeding Rs 1 lakh in a financial year realized from equity instruments such as ELSS attract LTCG tax of 10 percent. However, the higher upside potential of ELSS over the long term would also ensure that the post-tax return of quality ELSS funds would continue to outperform tax-free PPF returns by a wide margin.

Liquidity

The biggest disadvantage of PPF lies in its lack of liquidity. PPF comes with a lock-in period of 15 years and allows partial withdrawal and premature closure. Partial withdrawals are allowed only once a year starting from the seventh year of subscription. Premature closure is permitted after five years for treating life-threatening diseases of the account holder, spouse, dependent children or parents or for funding higher education of the account holder or any dependent children and in case of change in residential status. While investors can avail loan against PPF deposits from the third to fifth year, the loan amount has been capped at 25 percent of the balance available two years prior to the loan application year.

With a lock-in period of just three years, ELSS offers better liquidity compared to other Section 80C tax saving investment options. Although it is always advisable to stay invested in ELSS schemes for the long term, having the option to redeem after three years increases investors’ financial flexibility.

Also read: DCB Bank and Yes Bank offer the best interest rates on tax-saving deposits

Compulsory minimum annual investment

PPF subscription requires a minimum investment of Rs 500 per year during the entire subscription tenure. Failing to do so attracts a penalty of Rs 50 per year, apart from clearing the arrear subscription money of Rs 500 per year. On the other hand, ELSS schemes have no such requirement of compulsory annual investment. Investors can choose to stop or pause their SIPs any time without incurring any penalty.

Also read: 5 tax-saving investments for you

Conclusion

PPF is primarily aimed at encouraging savings for long-term financial goals. However, with better returns, higher liquidity and ease of investment, ELSS has established itself as an efficient investment tool for the twin purposes of tax-saving and long-term wealth creation.

While picking ELSS schemes, make sure you compare the performances of various ELSS funds over the last three-year and five-year periods with their benchmark indices. Although past performances do not guarantee future ones, comparing funds will assist you in finding how various ELSS funds have performed during the previous market and economic cycles.
Naveen Kukreja
first published: Feb 25, 2021 09:20 am

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