It often hurts when you have to part your hard-earned income with someone else, literally, with little or no tangible benefit in return. Over the years, there have been two “enemies of wealth creation”, namely inflation and tax, that have been taking a sizeable share from your income. Nothing much can be done about the former, apart from dealing with it by investing in an asset class that provides positive real rate of return. However, much can be done about the latter, by investing in instruments that help you save tax. Taking the argument one step further, is there an instrument that tackles both?
With majority of household wealth in India still parked in fixed deposits (FD), it clearly shows that Indians have been risk averse when it comes to investing. For long, tax planning meant investing only in traditional savings instruments like Public Provident Fund (PPF) and the National Saving Certificates (NSC). However, the problem with such instruments is that they seldom beat inflation and have often provided negligible real returns over the long term. In NSC's five-year-period deposits with banks and post offices, the interest gets added to your income and, therefore, is liable to be entirely taxed. So, even though these instruments help you save tax in the current year, there is a tax outgo on the interest income earned at the end of the tenure. Thus, for someone who pays 30 per cent tax, the post-tax return on a five-year bank FD of 7 per cent is only 4.9 per cent. Further, the lock-in period under such instruments is also high ranging from 5 years to 15 years.
Equity Linked Savings Schemes (ELSS) can be a good substitute to such traditional investment avenues, as they aim to provide tax-efficient long-term real returns. ELSS are open-ended diversified equity schemes with predominant allocation in equities. The investment in such schemes qualifies for deduction from gross total income under Section 80C of the Income Tax Act 1961, up to Rs 1.5 lakh a year along with other prescribed investments.
An important feature of ELSS is that it has the lowest lock-in period among tax-saving instruments—three years as compared with 5 years for PPF, 5 years for bank FD and 6 years for NSC. Although the primary purpose of investing in ELSS is to save tax, one should not forget it also serves in fulfilling incidental financial goals, like creating long-term wealth for distant goals such as retirement planning. Over the years, ELSS has generated superior returns as compared with PPF. For example, five-year compound annual growth rate in ELSS category is 18.60 per cent against PPF return of 8.52 per cent, which means that an investment of Rs 1.5 lakh in ELSS has grown to Rs 3.52 lakh against Rs 2.25 lakh in PPF (data as on December 31, 2017).
Further, one need not wait for the end of the financial year to invest in these funds. Investors can start investing via the systematic investment plan (SIP) route from the beginning of the financial year. This would encourage the habit of disciplined investing, and also average-out the cost of the investment. For example, a salaried employee with PF deduction of Rs 2,000 per month (Rs 24,000 per annum) and insurance premium of Rs 6,000 per annum can spread the balance amount of Rs 1,20,000 (Rs 1,50,000 – Rs 24,000 – Rs 6,000) for Section 80C deduction via SIP in ELSS funds with equal instalments of Rs 10,000 per month.
To sum up, ELSS funds are one of the best avenues to save tax under section 80C. This is because it provides twin-benefits of tax deduction and potential upside from investing in the equity markets. Also, no tax is levied on dividends and long-term capital gains from these funds. Moreover, compared with other tax-saving options, ELSS has the shortest lock-in period of three years.
As the saying goes ‘Mutual funds sahi hai’ for investment avenues; for tax-saving products, we can certainly say that ‘ELSS sahi hai’, as they clearly stand out in terms of liquidity, return and taxation.
The author is senior vice president & head—products & marketing, HDFC Asset Management Co. Ltd.