How to Drive your Money in ELSS for Tax Saving.....!!

The end of the financial year approaches and investors begin a mad scramble for tying up their tax saving investments. Some even wait till the last week before hurriedly investing in something recommended by a colleague or promoted heavily in the media. Tax saving is what is done to save one's tax liability for the current year whereas investing is what is done to build wealth over the long-term.

However such an approach needs an urgent rethink. Your tax saving investments are actually no different than regular investments. The Rs. 1 lakh deduction under Section 80C is available in respect of investments made in bank fixed deposits, post office deposits, senior citizens' saving schemes, PPF, insurance and mutual funds (ELSS), etc. The tax saving is just the icing on the cake. In other words, while tax deduction is an important thing to look at, it is more essential to consider what one would achieve out of that investment. The purpose of the investment is more important than the investment itself.

What is ELSS?

Equity Linked Saving Scheme (ELSS) is an equity mutual fund and has a lock-in period of 3 years. It has a minimum of 80% exposure in equity and upto 20% in debt, money market instruments, cash or even more equity.

Why ELSS?

Keeping in mind the optimal returns criteria, ELSS offers a good bet (although at a higher risk) since it is linked to equity. However, one has the option of investing via the Systematic Investment Plan (SIP), which will not only be easier on the pocket, but will also provide the benefit of rupee cost averaging. These funds have the shortest lock-in among all the tax-saving vehicles (3 years). The NSC or National Saving Certificate has a lock-in of 6 years, PF or Provident Fund (15 years) and KVP or Kisan Vikas Patra (over 7 years). Recently, 5-year bank fixed deposits have also been recognized by the government as one of the tax saving options.

The ELSS Advantage

How does an ELSS give you the two-in-one advantage of saving tax and building wealth? The graph below is an eye opener.

If three separate investments of Rs. 1,000 each were made in March 2000 into NSCs, PPFs and in an ELSS how would they fare?
The Rs. 1,000 invested in an ELSS would have been worth approximately Rs. 4,700 as on 31st March 2010. In sharp contrast, none of the fixed rate savings would have been worth worth more than Rs. 2,300. If you are willing to ride the ups and downs of the market, you find that an ELSS could be an ideal way to save tax and create wealth for your future.

Investment of Rs 1,000 in different Tax Savers: 2000-2010*

Take for example ELSS (Equity Linked Saving Schemes). With these having been all the rage till last year, this time around, investors have been avoiding ELSS and choosing guaranteed return products even for tax saving investments. However, here's another perspective. Everyone agrees that equity presents the best option for building wealth over the long-term. The problem however is that no one wants to undertake the risk of capital loss over the short-term for the sake of appreciation over the long-term. But let's take a step back and think about it. Say you are in the 31% tax bracket (30% + 3% education cess). Now what this means is that the moment you invest Rs. 1 lakh in an ELSS fund, you automatically get a return of 31%! Putting it differently, you will not have to pay tax of Rs. 31,000 due to your investment of Rs. 1 lakh. In other words, you have earned Rs. 31,000 the moment you invest Rs. 1 lakh.

So the capital loss, if any, will only take place if the market (and your investment along with) were to fall by over 31% hereon. As I write this, the Sensex is at 8902. A 31% fall from here would mean a Sensex level of 5542. Therefore, if and only if, the Sensex were to fall to a level below 5542 will you actually incur a capital loss. On the other hand, over the next three years, the possibility of the market recovering - if not to the erstwhile level of 21,000 but at least to a level higher than the present 8902 is more plausible than the other way around. And if this happens, your return would obviously be higher than 31%!

Now, the 31% tax saving translates into an immediate return but any ELSS investment has to be held for at least three years. So, the correct way of looking at this will be to spread the 31% over three years. This would assume that the market remains flat throughout, neither does it fall nor does it rise. In such a case, the rate of return person in the 31% tax bracket would be 13% and that for a person in the 34% tax bracket would be 14.9% p.a. tax-free.

Perhaps your immediate reaction to the above argument would be that this 31% yield due to the tax saving is not limited to an ELSS investment only - one can get the same benefit from any investment that saves taxes like say PPF, Bank FDs, or any of the other instruments enumerated earlier. Quite true. However at this point I will like to take you back to the fact that over the long-term, equity has the potential of delivering the highest return. So, say over a five year period, an ELSS fund should almost certainly give you a much better return than a bank FD or a Post Office deposit.

Conclusion

Overall, ELSS is a good investment vehicle to save tax as well as to grow your investments over the long term. You can reap better returns from appreciation in equity markets over the long term. You can also choose the SIP route to avoid ups and downs of markets. If you really want to reap the rewards of your tax saving investments, think beyond the lock-in period of three years. Over the long-term, returns from equities have always been greater than any other investment. So, what are you waiting for? Drive your money in the ELSS vehicle to save tax as well as create wealth over the long term!