Benefits of Equity Linked Savings Schemes go beyond tax savings

While planning for tax savings many investors veer towards the traditional saving avenues like Nations Savings Certificate (NSC), Life insurance premium and even bank fixed deposits (of five years and over).

While many investors tend to ignore a better avenue, which is not just savings oriented but is categorised as investment. Equity Linked Savings Schemes (ELSS) are a category of mutual funds which qualify for tax savings under section 80(C) to the limit of Rs 150,000 per each financial year. 

These behave like any other equity oriented mutual funds (MF) but have a lock-in i.e. the investments in these funds can’t be accessed by the investor for a period of three years from the date of investment despite them being open-ended MF schemes. The allocation in these funds is predominantly into equity and related instruments with a goal to create wealth in the long-term. 

The logic behind for providing tax-relief (during the investment) by the government is to encourage individuals to opt for higher productive avenues that benefit them in the long-run. When compared to other investment avenues that qualify under this section for tax relief, these investments also hold the shortest lock-in (restrictions for withdraw or access) period among all.

However, equity investments shouldn’t be made with such a shorter duration in mind but these being open-ended schemes help the investor to hold on to them even post the restriction period of three years. 

True to their investment philosophy, the nature of these investments bare higher risk when compared to all other avenues qualifying tax breaks under this section. As they always say, the time spent in the market defines the benefits or returns when investing in equity.

Innumerable research points out that the equity investments end up providing superior returns when invested for longer periods of time, as greater volatility is experienced by the stock markets in the short-term only.

So, considering someone is prepared to wait for similar holding periods of any other avenues in this section, then ELSS would prove to be a wise decision. For instance, the other avenue which qualifies for tax savings in increasing order of holding period is a 5-year bank deposit.

Data suggests that investing in equities over a 5-year period reduces the volatility by a large extent and increases the incidence of enjoying higher returns, though the returns from bank deposit could be lower but are assured.

While juxtaposing a Public Provident Fund (PPF) with a 15-year timeline and an ELSS, the latter could greatly outscore the PPF. Various data points across the major equity markets show that the possibilities of losses are almost nil while the incidence of double-digit returns is quite realistic. 

The other advantage both for the fund manager and the investor is the lock-in which removes the redemption pressure generally experienced by the management team during the short-term volatility in any of the other open-ended MF schemes.

Here, the fund manager gets a longer rope to operate and take decisions accordingly which could benefit the investor with similar time horizons. Also, this could act as a very good investment for the first-time equity investor where they could enjoy all the benefits of diversification, lower costs and professional help while they are devoid of making any knee-jerk reactionary decisions. 

Most of the first-time equity investors convert their nominal losses to real by moving out of the equities in times of volatility but as the funds here are inaccessible, they get bound and thus offset any such impulsive decisions. Moreover, the funds being open-ended they could stay invested beyond the lock-in period if they didn’t find any requirement with funds or if they find the prevailing market conditions are adverse. 

The long-term capital gains (LTCG) is similar to any of the other equity-oriented MF and is taxed at 10 per cent of the gains. Considering that the entire earned interest is taxed in NSC or bank deposits, it translates to a better trade-off. Similarly, the longer lock-in in PPF could be offset with the flexibility offered beyond three years in these instruments. 

A word of caution is that these investments doesn’t fit for all individuals and risk categories. One should be aware of their risk tolerance and see if they could digest the volatility associated with equities. Also, keep in mind the kind of commitments and timelines they have while making investments into these funds. Certainly, a portion of investment could be allocated into the portfolio within this tax saving section or otherwise too.  (The author is co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)