Despite LTCG tax, MFs biggest wealth generator for retail investors

Equity-linked saving schemes (ELSS) will not offer totally tax-free returns anymore. Due to a 2018 budget proposal, even these tax saving mutual funds (MFs) would attract long-term capital gains (LTCG) tax on profit exceeding Rs 1 lakh made from the sale of such scheme units held for over one year. Many investors are miffed about paying the LTCG tax, arguing that a large part of their future gains will be taxed. However, experts think that in the current situation even after paying tax ELSS category is still the biggest wealth-creating opportunity among all options available for retail investors like you and me. Read on to find out why.

ELSS staple

For investors wanting to use Section 80C for tax-saving, ELSS is a popular avenue managing assets worth Rs 83,000 crore. By regularly putting in small amounts of money like Rs 500/month, ELSS products, which have a three-year lock-in, helped the common investor to save tax, and also create wealth. Section 80C allows you to invest Rs 1.5 lakh and reduce your taxable income by that amount.

Compared to other Section 80C tax-saving investment avenues, ELSS have some unique benefits. Firstly, the low lock-in period. Your money is locked-in for just three years, as against much longer lock-in periods in other options like public provident fund (15 years) and tax savings bank deposits (five years).

Secondly, you can earn market linked returns. Since investments are predominantly made in stocks of Indian companies, the value of your investment moves with the stock market. Although it comes with market-related risks, your money is diversified i.e. spread out across stocks of multiple companies and is monitored by an investment expert with an aim to minimize such risks. With systematic investment plans (SIPs), the ELSS returns are even better.

For new ELSS investments, it is true that investors should understand that 10% of whatever profits are made gets shaved off. But that does not significantly hurt you because taxes are paid on gains that you make (see chart). "One thing which is good is that higher your holding period for the investment, the lower is the impact on the CAGR due to this tax, other things remaining same," says Gautam Sinha Roy, MOSt focused long-term fund (ELSS) fund manager.

First among equals

With ULIP maturity returns not facing any form tax, there is, of course, the argument over which tax-saving option investors should choose. However, ULIPs combine insurance and investment. If your insurance needs are already met, personal finance experts say that paying for the cost of insurance in ULIP is not a smart idea. ELSS product category is purely investment oriented in that sense, with no insurance link.

Under Section 80C, you as an individual or Hindu Undivided Family (HUF) can reduce up to Rs 1,50,000 from your total taxable income by investing in insurance, PPF, expenses incurred towards tuition fees etc. "But one must note that the wealth generation opportunity offered to a taxpayer is very big in case of ELSS. The debt based avenues like PPF and tax saving bank fixed deposits do not generate the kind of returns ELSS has done. The expense deduction for tuition fees can help you lower taxable income, but that's it. ELSS is still the biggest wealth generating opportunity for investors who want to save tax and also grow wealth," says Dhirendra Kumar, CEO, Value Research.

Value Research data shows that five-year SIP returns on tax-saving MFs range between 10-20% annually. Over a 10-year period, the returns range between 13-19% and over a 20-year period the SIP returns are between 16 to 24% every year.

The stand out feature of equities is that while it is a volatile instrument for short-term holding, it is a very powerful wealth creation engine over the long term. ELSS schemes not only give you a tax protection as they fall under Sec 80C. But, more importantly, because of the three-year lock-in of the product, the investor is forced to become a long-term holder. "Hence he/she is in a better position to really benefit from the wealth creation potential of the instrument, rather than get trapped in the volatility aspect. It also brings in a certain discipline in saving and channelizing the saving in the correct long-term saving instrument- which is Equity," adds Roy, whose fund has the best three-year SIP return among three dozen products.