(This article was first published on Yahoo Finance.)
ELSS funds are Equity Linked Savings Scheme that earn investors a tax deduction of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. ELSS funds are one of the many 80C investment options that you can use to save on income taxes before 31st March. While they are one of the best tax-saving investments available today, a lot of people tend to ignore them because they are probably not as easy to understand as some of the traditional tax-saving investments like Public Provident Fund (PPF) or Tax-saving Fixed Deposits (FD). However, ELSS funds are highly-recommended by tax and investment experts.
Here are 5 reasons why you should be investing in ELSS funds.
Lowest lock-in among tax-saving investments
One of the major problems that people have with tax-saving investments is the long lock-in periods they come with. The PPF has a lock-in of 15 years, the Employee Provident Fund (EPF) and National Pension System (NPS) requires you to stay invested till you retire, other options like FDs have a lock-in of at least 5 years. Compared to all of them, ELSS funds have a lock-in period of only 3 years. This means you don’t have to compulsorily stay invested in them for long periods. You can redeem your invested amount after a period of 3 years.
The important thing to understand about the lock-in of ELSS funds is that when you’re investing in them through Systematic Investment Plans (SIP), each individual SIP will carry a separate lock-in of 3 years. So, for example, if you began an SIP of Rs 1,000 a month in an ELSS fund in April 2013 and invested every month for 3 years, your entire accumulated amount would not be up for redemption upon completion of the 3 year lock-in period in April 2016. Only the Rs 1,000 invested in April 2013 and the gains on it would be redeemable in April 2016. This is because each SIP carries an individual lock-in and redemptions are done on a first-in-first-out basis.
But this doesn’t mean that you invest in an ELSS fund in lump sum. SIPs are the best way to put money in ELSS funds. We’ll elaborate why.
Investing through SIPs
SIPs are systematic investments that allow you to designate an auto investment in a fund at a fixed date every month. Let’s say you decide to invest Rs 1,000 in an ELSS fund on the 10th of every month. Under an SIP intimation, your bank will automatically transfer the amount through ECS from your account to the mutual fund. You don’t need to bother about doing it every month. You also don’t need to invest one big amount at the end of the financial year to meet your 80C requirement. You can invest a small amount every month and get the same tax benefit at the end of the year without putting any sort of burden on your monthly budgets.
Automated investments are good but that is a secondary benefit of SIPs. The primary benefit is that SIPs give the advantage of rupee cost averaging. Let’s understand rupee cost averaging. As we all know, the equity markets fluctuate a lot. The markets are up one month and down the other. If you invest in one go, you run the risk of catching a market peak. But with an SIP, you can invest at different levels of the market. When the markets are low, you are alloted a higher number of units and lesser units when the markets are high for the same amount. This is how your average cost of investment remains at a level that can earn you the best returns. This won’t be possible if you invest in a lump sum.
No maturity date
ELSS funds don’t have a maturity date. This is a big advantage because you can continue investing in them even after the lock-in period has expired. Your investment in an ELSS fund can be continued with or without further contributions. There are some other tax-saving investments, like the PPF, that allow you to continue investing after the lock-in but most options don’t give this facility. This is an important advantage for ELSS funds because here you earn returns from the power of compounding interest.
Compounding interest is where you generate returns on not only the amount you invest but on your earnings as well. Let’s say you invested Rs 1,000 in an ELSS fund through an SIP and your annual return from it was 12% or Rs 120. This interest earned will be added to your invested corpus and would generate returns as well. So, next year, you would earn returns on Rs 12,120 accumulated in the first year as well as the new Rs 12,000 invested that year. Over a long period of time, this effect of compounding becomes even more lucrative because the more you invest, the more interest is added to your corpus. You keep generating returns on the invested money even if you stop investing further. This is how the benefit of compounding is a big advantage in ELSS funds.
Inflation beating returns
Another major plus point of ELSS funds is that they are largely equity-oriented investments. ELSS funds are mandated to invest at least 80% of their assets in equity and equity-oriented instruments. This is the highest equity allocation among all tax-saving investment options. Now, traditional investors will not like the high amount of equity exposure that comes with ELSS funds. After all, equity is a volatile asset class. News about the ups and downs of the stock markets are in the newspapers almost daily. We keep hearing stories about families that have lost everything they have had because of some bad equity investments. In short, our psyche has been governed to fear equity. But what we forget is that these bad things happen to speculators, traders and punters who try to make a quick buck out of the stock markets. The way to insulate yourself from the risks of equity and still get its benefits is by investing in equity mutual funds.
And the benefits are plenty. Equity is the only asset class that can help you generate returns that are higher than the prevailing rate of inflation. Fixed income investments like PPF and FDs cannot beat inflation. Equity might be volatile in the short run, but over the long-term it can earn superior returns that are more than the rate of inflation. This is important because your invested capital depreciates in value as inflation goes up over time. Everything that we buy will keep getting expensive. Rs 10,000 was a big amount two decades ago, but is not worth a lot today. Hence, our investments need to earn more that the rate at which our cost of living goes up. Only equity can generate such returns.
Diversify and switch funds
Probably the best thing about ELSS funds is that you can choose the funds you want to invest in, invest in more than one fund to diversify and switch a fund if you think it is not doing well enough.
Diversification is an important feature of equity mutual funds. The fund itself builds its portfolio by investing in stocks of different market capitalisation and companies from different sectors. This means your investments are made across the market with a professional fund manager making the investment choices for you. Over and above this diversification, you can also diversify across fund houses and investment styles by putting your money in more than one ELSS fund. If, for example, you plan to invest Rs 1 lakh a year in ELSS funds to earn the tax break under Section 80C, you can spread your investments across 2-3 ELSS funds instead of putting all the money in one single fund. The advantage you will get here is that all funds don’t perform in the same way every time. So, if one fund underperforms, it won’t have a major effect on your overall portfolio returns. You will also get the benefit of different investment styles and approaches.
And then if you want to stop investing in an underperforming ELSS fund, you can stop your SIPs in it any time you want and start fresh SIPs in another fund. You will have to stay invested in the fund till the lock-in expires, but at least you don’t have to continue investing in something that isn’t doing well. This is the kind of flexibility that other tax-saving investments don’t provide.
Apart from all of these advantages, the long-term returns from ELSS funds are completely tax-free because they are equity-oriented investments. So by the time your lock-in expires, your investments would have completed one year for the gains to qualify as long-term capital gains. You won’t have to pay any tax on them.
These are more than enough reasons anyone would need to invest in ELSS funds. Even if you are not comfortable with allocation your entire 80C investments to ELSS funds, you should have a major part of your tax-saving portfolio in them. A good mix would be 70% to ELSS funds and the rest to other fixed income tax-saving options. But if you’re young, you can afford to take more risks and allocate further to ELSS funds. They make an integral contribution to long-term wealth creation.