As the Union Budget removed the tax exemption on maturity proceeds of unit-linked insurance plans (Ulips) having annual aggregate premium of over Rs 2.5 lakh, equity-linked savings schemes (ELSS) of mutual funds will be preferred more by investors as these have the shortest lock-in period of three years, have lower expense ratio and give higher returns. For those investing for tax savings, ELSS can be a good option to not only save on tax, but also earn higher long-term returns.
Both ELSS and Ulips are eligible for tax deductions on investments under Section 80C of the Income Tax Act. However, for Ulips, the condition for tax deduction is that the premium should not exceed 10% of the sum assured. The lock-in period of Ulips is five years. The long-term capital gains (LTCG) booked from equity-oriented investments over Rs 1 lakh with holding period of over one year are taxed at 10%. One of the major advantages of taxing LTCG is that the long term losses are available for set-off against profits and also for carry forward for a period of eight years.
ELSS scores over fixed income products
Despite LTCG tax on ELSS, the effective returns are higher than some fixed income products such as Public Provident Fund, National Savings Certificates or bank deposits. Moreover, the lock-in periods in these fixed income products are higher than ELSS. The minimum investment limit in ELSS is Rs 500 and there is no cap on the maximum amount. However, tax benefit is only on investment up to Rs 1.5 lakh a year. An individual can invest a lump sum amount or invest every month through SIP. In fact, an SIP works best in falling markets when an investor is able to buy more units. An investor can even pause the SIP in case of any cash crunch. However, if one invests in ELSS via SIP, then each instalment will have a different maturity date.
Asset management companies offer three options in ELSS—growth, dividend payout and dividend reinvestment. If an investor opts for a dividend payout option, then the dividends are tax-free in his hands. Alternatively, if the investor does not need any regular cash flow, then he should opt for growth plans, which will help in getting the returns compounded. In the growth option, investors get the gains at the time of redemption which helps to appreciate the total net asset value.
As ELSS is a market-linked product, there is no guarantee of any assured returns. Fund houses invest in diversified stocks and sectors, which reduces the risks in case of any cyclical markets volatility. However, returns fluctuate depending upon the performance of the equity market and the stock selection of the fund manager. Data from Value Research show that returns for ELSS for one year is 23.94%, for two years it is 8.47% and for five years it is 14.45%.
For salaried employees, a mix of ELSS and EPFO will help to balance out risk and return on their investment portfolio. As the Budget has proposed that the interest earned on employees’ annual contribution to provident fund over `2.5 lakh will be taxable, salaried employees should diversify by investing in ELSS.
Before investing in any ELSS, an investor must analyse some of the key parameters such as Sharpe Ratio, Alpha and Standard Deviation to gauge the performance of the fund. The investor must also look at the track record of the fund manager and the consistency of the fund in terms of returns, stock picks and conviction. An investor must invest in funds that have performed consistently over a period of five years, compare the fund’s performance with funds and benchmark.