What is ELSS and how does it work? – Forbes Advisor INDIA
Creating wealth and reducing taxes payable are two essential goals that we all want to achieve. Although there are many financial instruments that help you do this, sometimes it becomes difficult to invest in different instruments to achieve these goals. In these testing times, when income is under pressure, investing in multiple financial tools can be a challenge. However, achieving the twin goals is also crucial at the same time.
Often people wonder if there is an instrument that can help them achieve both of these goals simultaneously? Fortunately, there is, and that is the Equity Linked Savings Plan or ELSS. Here’s what it means and how it works.
What is ELSS?
ELSS, one of the categories of mutual funds, invests primarily in stocks. In other words, ELSS funds invest a significant portion of their corpus in equities. The composition of ELSS funds is such that they are heavy on equity.
ELSS funds invest 80% of their corpus in equity-oriented instruments. Being heavy on stocks, they have the potential to generate returns above inflation over the long term.
Tax saving feature of ELSS funds
Note that investments in ELSS benefit from a tax exemption under Article 80 C of the Income Tax Act 1961. This means that the amount you invest in ELSS is eligible for a tax deduction provided it is below the threshold of INR 1.5 lakh. Under article 80 C, you benefit from an exemption on investments up to INR 1.5 lakh in a financial year. So, if you haven’t exhausted that limit, investing in ELSS can help lower your tax liability.
To put it numerically, if you invested 1 lakh INR in other instruments specified under Article 80C (PPF, NPS, life insurance, etc.) in a particular financial year, you still have an investable surplus of INR 50,000. Investing this amount in an ELSS fund can help you further reduce your tax liability.
ELSS blocking period
There is another essential feature of ELSS that you should be aware of. Investments in ELSS are blocked for three years from the date of investment. This means that you cannot withdraw funds for three years. The lock-in period is the minimum among all tax saving schemes. Many investors tend to be a little uncomfortable with the ELSS lock-in period.
However, foreclosure gives your money more time to grow. It is not recommended to withdraw cash unless absolutely necessary, even after locking. This is because the composition can weave its magic the longer you stay invested. Compounding plays an important role in increasing your wealth. At the same time, the quantum of volatility decreases if you stay invested for a long time.
Note that stocks are a volatile asset class. In the short term, they can be very volatile. However, if you stay invested for a long time, it significantly lowers the volatility. Additionally, it helps you stay invested through market cycles and brings discipline to investing.
How to invest in ELSS?
So how can you invest in ELSS? There are two ways – lump sum and SIP. In the first case, you invest a large sum all at once. On the other hand, if you invest through SIPs, a specific amount of money is invested in your chosen fund at regular intervals. Note that when you invest via SIPs in ELSS, each SIP is blocked for three years.
Reimbursement is made on a first in, first out basis (FIFO). This means that the locked SIP first is used first, and so on. While SIPs bring discipline to investing, the lump sum comes in handy when you have a surplus to invest.
How to choose an ELSS fund to invest?
This is one of the essential things to see when investing in a mutual fund and ELSS is no different. Make sure the underlying fund portfolio is strong and well diversified. If a fund is fundamentally sound, then it can contain declines better and handle volatility.
Long-term performance of funds relative to benchmarks and peers
This is another essential point of view. You need to consider the long-term performance of the fund and compare it to its benchmark and peers. It is advisable to opt for a fund that has consistently generated higher returns than its benchmark index and its peers.
Taking long-term performance into account will help you understand how the fund performed during a bear market and whether the returns have been consistent over the years.
Expense ratio and experience of the fund manager
Each fund house charges a fee in the form of an expense ratio for managing your investments. The ratio, expressed as a percentage, is higher for regular plans and lower for direct plans. A high expense ratio can reduce returns in the long run.
We must therefore be vigilant and opt for a fund with a competitive ratio. It is equally essential to take into account the experience of the fund manager. The performance of any fund depends largely on the calls taken by the manager. An experienced manager is better equipped to handle market volatility and can take cautious calls that can increase your earnings over the long term.
Risks of investing in ELSS
No return guaranteed
Being a market linked product, returns from ELSS are not guaranteed. Their performance depends on several factors affecting the markets. If the markets dip, the gains made can evaporate in no time. Unlike fixed income products, such as public provident funds (PPF) and bank term deposits, you cannot expect guaranteed returns from ELSS.
Unable to withdraw money for three years
If you need the money urgently, you cannot withdraw from your ELSS investment if the investment period has not exceeded 3 years. Whether you invest in equity or in SIP, you must wait 3 years before opting out. Therefore, before investing, you must be absolutely certain that you will not need the money invested in the fund for at least 3 years.
Poor performance of the underlying portfolio
Poor performance of the underlying portfolio can erode returns. If the decision made by the fund manager goes wrong, then there is a chance of poor performance. This will negatively affect any gains made and you may have to bear the brunt of the fund manager’s error in judgment. It is therefore advisable to opt for a fund managed by an experienced manager.
Who should invest in ELSS?
While anyone can invest in ELSS, it is an ideal investment choice for:
Individuals with high risk tolerance
Note that ELSS invests mainly in equities, a volatile asset class. If you have a high tolerance for risk and can handle volatility, you should consider investing in ELSS. On the other hand, if you are pissed off even at the slightest hint of volatility, it is advisable to stay away from ELSS.
Individuals in the high tax bracket
If you are in a high tax bracket and have a Section 80C surplus to invest, investing in ELSS can help you significantly reduce your tax expenditure. It is estimated that an individual in the highest tax bracket can save around Rs. 47,000 in taxes by investing in ELSS during a fiscal year.
Individuals with a long investment horizon
ELSS may be an ideal choice if you have a high tolerance for risk and want to approach equity investing with a long-term horizon. You can mitigate the volatility and risk of ELSS investments by staying invested for the long term – at least eight to ten years.
As is evident, investing in the right ELSS fund can do wonders for your wealth and help keep you on a solid financial footing. Not only can you reduce your tax liability, but also take advantage of the potential of stocks to increase your wealth.