Capture equities upside, save tax with ELSS

There was a very interesting article a few weeks back on the Wall Street Journal. It spoke about financial mistakes you are likely to make at different ages in life.

One point stood out.

"One nightmare scenario for many in their 50s is the realisation that they may not have enough money stashed away for retirement," the article stated.

This is quite true. So many people in their 50s and 60s cut down their spending and compromise on their lifestyles because of limited savings. When they had the money, they had no time. Now they have the time, but no money. Many even rely entirely on their children or relatives.

And yet, the solution to this problem is simple: Investing when you are young.

Don't play it safe

It is equally important to invest right. To avoid risk, many invest in low-risk options like fixed deposits and public provident funds (PPFs) at a young age. By doing so, they let go of the possibility of higher returns—the very thing that builds and sustains the wealth through their life. Remember, if you have a salary, that is your fixed income! Your savings need to be invested in the market if you are looking to build a corpus for retirement. Your long-term needs like retirement require a long-term investment horizon in avenues like equity markets. For instance, the compounded annual growth rate (CAGR) for public provident fund (PPF) over 15 years has been around 8.3 %. The BSE Sensex has returned 14.7% CAGR in the same period (source: ICRA online-MFI explorer).

Investing for wealth, not just tax-saving

And then there's that matter about tax. Few know that they can save a great amount of tax by investing Rs 1.5 lakh a year. This is akin to giving Rs 46,350 (@ 30.9%) for free. In other words, you can set aside Rs 1.5 lakh of your taxable income in which you need not pay tax if you invest this amount in options that we shall talk about below.

It is very important for all of us to file our taxes on time and pay our dues to the country. But here are a few options that the government has provided to shield part of your returns from taxes - Public Provident Fund (PPF), National Pensions Scheme (NPS), Post Office Deposit, five-year Bank Deposit, Life Insurance, and Equity Linked Savings Scheme (ELSS) (and Rajiv Gandhi Equity Savings Scheme (RGESS) too if you are a first-time investor).

How do you choose the right option? After all, they save tax in more-or-less the same way. So what you must compare are the risk and return aspects.

And this is where ELSS really shines.

ELSS v/s the rest

Let's do some simple number-crunching. We will start with Rs 1.5 lakh, the maximum amount you can invest in the tax-saving options. (Note: This does not include the NPS, which gives you an extra exemption of Rs 50,000.)

Now, for the sake of comparison, let's assume you invested Rs 1.5 lakh every year for two decades. This means, you invested a total of Rs 30 lakh.

Had you invested in a PPF, this money would have grown to Rs 82.14 lakh as of 2015—an average yearly return of 9.59%, as per Value Research. That's a great amount, probably one of the reasons why PPF is the go-to option. This, though, is likely to not continue in the future considering the fall in interest rates.

Now let's look at the average yearly returns from ELSS funds. Your Rs 30 lakh investments would be worth Rs 2.74 crore—thrice the PPF portfolio value. This means, you would have gotten an average yearly return of 19.81%. Remember, this is despite the stock market going through two crises in the 20-year period!

Bottom line: Had you invested in ELSS, you would have easily been a Crorepati today, while also saving taxes!

Kicker of equity with a lesser lock-in period

Along with tax deduction, ELSS funds offer investors the potential upside of investing in the equity markets. Unlike the West, we believe there is a lot of alpha in the Indian markets, i.e, most funds outperform their benchmarks. Also, no tax is levied on the long-term capital gains from these funds nor are the dividends taxed. Moreover, compared to other tax saving options, ELSS has the shortest lock-in period of only three years.

Instrument Lock-in Period

ELSS 3 Years from the date of allotment of the respective Units       
Bank Fixed Deposit 5 Years       
PO Time Deposit 5 Years       
NSC 6 years       
PPF 15 Years (Partial withdrawal after 6 years)
Source: Banks and Post Office
It's not just for 3 years.

A common mistake that many ELSS investors make is selling after the three-year lock-in period ends. This is because they assume the Fund becomes riskier. Also, if you withdraw after three years and don't need the money, you will need to reinvest it again and stay invested for a certain amount of time again to avail of gains without taxes. So, it makes sense to stay invested till you really need the money.

A last problem to solve

It's not just about where you invest, but also how.

January and March is when most people sit down to reconcile their finances for tax. And this is when a lot of investors scramble to invest their money.

If you find yourself doing the same, ask yourself this: Do you want to spend Rs 1.5 lakh at one go? Does your bank balance support such lump-sum expenditure? Wouldn't Rs 12,500 per month be easier?

So, think small. Look at investing Rs 12,500 every month in mutual funds. It amounts to Rs 1.5 lakh.

This has a three-pronged benefit.

You reduce financial pressures in those two-three months.

You discipline your finances. By investing first, you automatically limit your unwanted expenses. Plus, you are not likely to forget or postpone investments.

By investing monthly, you can buy MF units at different values. This way, you can buy more during market lows. This lowers your average cost of buying the MF units. Your profits, thus, could increase.

A last word

An Equity-Linked Savings Scheme is like that one stone you use to hit two birds at once. Consider it like the 'Buy one, get three free' discount offer. Not only is the Rs 1.5 lakh of taxable income exempt, all income in the form of dividend and gains on this investment are also exempt. You invest to save tax today. Plus, you could manage to gather wealth for tomorrow.

With such an easy option available, it surely pays to take a systematic approach.

The writer is executive vice president, head - sales and marketing, DSP BlackRock