What are Equity Linked Savings Schemes and their benefits

Of the various Tax saving options under Section 80C of Income Tax Act 1961, mutual fund Equity Linked Savings Schemes (ELSS) have the maximum wealth creation potential over a long investment horizon. Equity Linked Savings Schemes (ELSS), also known as Tax Saver Funds are equity mutual fund schemes which invest in a diversified portfolio of stocks with the objective of generating capital appreciation for investors over a sufficiently long investment horizon. Investors can get tax deduction of up to Rs 150,000 from their taxable income by investing in Equity Linked Savings Schemes (ELSS) under Section 80C of Income Tax Act 1961. Investors can save up to Rs 46,350 in taxes every year by investing in Equity Linked Savings Schemes (ELSS).

Equity Linked Savings Schemes (tax saver funds) have a lock-in period of three years; investors cannot redeem ELSS units before 3 years from the date of investment. Investors can invest in Equity Linked Savings Schemes in lump sum or through Systematic Investment Plans (SIP). By investing in Equity Linked Savings Schemes through Systematic Investment Plans, investors can not only meet their tax saving goal, but can also take advantage of volatility in stock markets through Rupee Cost Averaging. However, when investing in Equity Linked Savings Schemes through Systematic Investment Plans (SIPs), investors should note that, each Systematic Investment Plans instalment will be locked in for three years.

You can invest in either Growth or Dividend Options in Equity Linked Savings Schemes. Investors should note that Dividend Reinvestment Option is not available in Equity Linked Savings Schemes. This is because the lock-in clause of Equity Linked Savings Schemes may result in the dividends re-invested in the scheme to be locked in indefinitely. The dividend option of Equity Linked Savings Schemes provides investors with the option of getting tax free income from their Equity Linked Savings Schemes investment during the lock-in period and beyond. Investors should however note that mutual fund dividends are paid at the discretion of the scheme’s fund manager. There is no assurance with regards to timing or amount of dividends paid by mutual funds.

How to invest in Equity Linked Savings Schemes?

It is very simple to invest in Equity Linked Savings Schemes. If you are an existing mutual fund investor, you need to ensure that your KYC (Know Your Customer) is verified and valid. Your mutual fund can check if your KYC is verified using your Permanent Account Number (PAN). You can yourself check if your KYC is verified by going to the CDSL https://www.cvlindia.com/ website. If your KYC is verified then, you can fill up the relevant mutual fund application form available on Asset Management Companie’s (AMC) websites and invest in Equity Linked Savings Scheme.

If you are a new mutual fund customer, you need to submit your KYC documents (PAN card, colour photograph and address proof) along with the relevant KYC form (available on the AMC website) or with your financial advisor (mutual fund distributor) and submit it to the concerned AMC or the Registrar and Transfer Agent (R&TAgent). Your financial advisor can help you with the submission or you can directly submit it to the AMC / RTA. You can submit your ELSS application form along with the KYC documents. Once the KYC is verified the AMC will allot you units of the ELSS funds.

Wealth Creation Potential of ELSS

Section 80C investment schemes can either be risk free or subject to market risks. Public Provident Fund, National Savings Certificates, Tax Saving Bank FD schemes, Tax Saving Post Office time deposit schemes etc. are examples of risk free investments, while mutual fund ELSS and ULIPs (Unit Linked Insurance Plans) are subject to market risks.

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If you do not want to take any risk, then Equity Linked Savings Schemes (tax saver mutual funds) or Unit Linked Insurance Plans (ULIPs) are not the right investment options for you. However, note that risk and return are directly correlated; you cannot get higher returns without taking risks. Even though Equity Linked Savings Schemes are subject to market risk, they are one of the best tax saving investment options for you, if you have long investment horizon.

Historical data shows that, equity is the best performing asset class over a long investment period outperforming asset classes like gold and fixed income (debt). In the last 20 years from January 1997 to January 2017, the BSE Sensex has given 11.1% annualized returns, while gold has given 9.3% and fixed deposits have given 7.6% annualized returns respectively. Rs 1 lakh invested in the Sensex twenty years back would have grown to Rs 8.2 lakhs, while the same amount invested in gold and fixed deposit would have grown to Rs 5.9 lakhs and Rs 4.3 lakhs respectively.

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Let us assume you invested Rs 12,500 every month (annual Rs 150,000) in an Equity Linked Savings Scheme each year (at the beginning of the financial year) for the purpose of tax savings. If you are in the highest tax bracket, you will be able to save Rs 46,350. Over a 20 year period you will be able to save almost Rs 9.3 lakhs in taxes. Let us now see the wealth creation potential of ELSS. Assuming an annualized return of investment of 11% you will accumulate a corpus of Rs 1.09 Crores over a 20 years period (ELSS category has actually given over 11% annualized returns in the last 10 years). If you combine tax savings and wealth creation, the financial benefits of ELSS investments over a sufficiently long investment period is huge.

Superior Liquidity of ELSS compared to other 80C tax saving investment schemes

Equity Linked Savings Schemes (tax saver mutual funds) offers higher liquidity compared to all Section 80C investment options, other than Equity Linked Savings Schemes. 80C investments like NSC, tax saving bank FDs, post office tax saving time deposits, Unit Linked Insurance Plans etc. have a lock in period of 5 years. Public Provident Funds (PPF) has tenures of 15 years with limited liquidity in the interim. Traditional life insurance policies also have long maturity tenures and if you surrender your policy within a certain period from the policy inception date then you stand to lose a lot in surrender value. Equity Linked Savings Schemes (ELSS) investments have a lock-in period of 3 years and this makes them the most flexible Section 80C investment schemes from a liquidity perspective.

Lock-in period of ELSS can benefit investors over a sufficiently long investment horizon

Though the liquidity of Equity Linked Savings Schemes (tax saver mutual funds) investments is restricted in the first three years of the investment, over a long investment period, the 3 year lock in period in Equity Linked Savings Schemes is to the advantage of investors compared to open ended diversified equity funds.

Since the investor cannot redeem units of the scheme in the first three years, they are not affected by redemption pressures on account of short term volatility, which enables the fund manager to stick to his long term stock convictions. In the last 5 years Equity Linked Savings Schemes (ELSS) on an average delivered 20% annualized returns outperforming the broader market; top performing 5 years Equity Linked Savings Schemes delivered nearly 25% compounded annual returns over the last 5 years.

Post the lock-in period of 3 years, the units in the scheme becomes free and if the investor wishes, he or she can redeem the units partially or fully to reinvest the proceeds again for saving taxes for the FY in which redemption is made. This is an idea which can work for investors who do not have liquidity in hand but need to invest to save taxes under Section 80C.

Tax Benefits of ELSS

Equity Linked Savings Schemes (tax saver mutual funds) are also the most tax friendly investment schemes among the eligible Section 80C investment options. There is no taxation during the investment period, unlike many fixed income investment options. Since Equity Linked Savings Schemes are equity oriented schemes with a minimum investment period of three years, long term capital gains from Equity Linked Savings Schemes are tax free. Dividends paid by Equity Linked Savings Schemes are also tax free. Therefore, returns from Equity Linked Savings schemes, either in the form of capital appreciation or dividends are completely tax free.

Conclusion

In this post, we discussed about Equity Linked Savings Schemes (tax saver funds) and their different characteristics. Investors should know that Equity Linked Savings Schemes are equity market investments. Equity markets can be volatile in the short term and therefore, investors should be patient and have a sufficiently long investment horizon for Equity Linked Savings Schemes. We also discussed the various benefits of investing in Equity Linked Savings Schemes. Equity Linked Savings Schemes are one of the best Section 80C investment options. Equity Linked Savings Schemes offer superior wealth creation potential, liquidity and tax benefits compared to other Section 80C investment schemes. You should discuss with your financial advisor if Equity Linked Savings Schemes are suitable for your tax planning investments.