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Home » Six Tips for Investing in Tax Saving ELSS Mutual Funds

Six Tips for Investing in Tax Saving ELSS Mutual Funds

Six Tips for Investing in Tax Saving ELSS Mutual Funds

We all love to save tax. Don’t we? There are many tax-saving products that help us save tax. PPF, NSC, Bank Fixed Deposits, Life Insurance policies are some examples of such tax-saving products. ELSS or Equity-linked Savings scheme, or simply Tax Saving Mutual Funds, are an excellent avenue, not just for saving tax, but also for earning much more on your investment.

1. Look for After-Tax Rate of Return

When we evaluate different products, we should not just be comparing the nominal returns, but also the effective returns after accounting for tax. How much return do we get, after deducting taxes and inflation (increase in the cost of living)? Let us understand this by taking the example of a Fixed deposit.

You can save tax by investing in a Bank FD for 5 years. Let us assume that the FD is done on April 1, 2016, and the bank offers 8% p.a. interest. There is a lock-in period of 5 years. If you invest Rs. 100,000, assuming you are in the 30.9% tax bracket, you save tax of Rs.30,900. Thus, your net investment is Rs.69,100. Every year, you earn Rs.8,000 as interest. However, this interest is fully taxable. Since you are in the 30.9% tax bracket, you pay a tax of Rs.2472. Thus, your net post-tax income is Rs.5528. This works out to an effective post-tax return of 8% p.a. So, What is the big deal?

Let us now look at a Tax Saving Fund. Let us assume that the fund also earns a return of 8% p.a. If you invest Rs. 100,000, assuming you are in the 30.9% tax bracket, you save tax of Rs.30,900. Thus, your net investment is Rs.69,100. Every year, you earn Rs.8,000 as a dividend or capital appreciation. However, both dividend and long term capital gains are fully exempt from tax. Thus, you DO NOT pay any tax. Thus, your net post-tax income is Rs.8000 on investment of Rs.69100, which works out to an effective post-tax return of 11.58% p.a.

2. Don’t Underestimate The Power of Compounding

The difference of 3.58% or Rs.2472 in itself is significant. However, this difference gets further compounded when you look at the entire period of 5 years. For simplicity, let us assume that the income accrued in the following years as Interest/ Dividend is re-invested in the same scheme year after year. Then the returns for FD and ELSS will work out as under:

Fixed Deposits

      Date01 April   201601 April 201701 April 201801 April 201901 April 2020Total
You invest            1,00,000                 5,528                     5,834                     6,156                     6,496         1,24,014
Tax Saved             30,900                 1,708                     1,803                     1,902                     2,007             38,320
Net Investment             69,100                 3,820                     4,031                     4,254                     4,489 
Interest Earned                 8,000                 8,442                     8,909                     9,401                     9,921 
Tax on Interest                 2,472                 2,609                     2,753                     2,905                     3,066 
Net interest                 5,528                 5,834                     6,156                     6,496                     6,855             30,870

Tax Saving Mutual Funds or ELSS

Date01 April 201601 April 201701 April 201801 April 201901 April 2020Total
You invest                 1,00,000               8,000                     8,640                     9,331                 10,078       1,36,049
Tax Saved30,900 2,472                     2,670                     2,883                     3,114           42,039
Net Investment69,100 5,528                     5,970                     6,448                     6,964 
Interest Earned                     8000               8,640                     9,331                   10,078                 10,884 
Tax on Interest                     –                     –                             –                             –                           – 
Net interest               8,000               8,640                     9,331                   10,078                 10,884           46,933

As can be seen from the above tables, the difference is Rs.16,063 or 52% higher!

3. Beware of The Lock-in Period

ELSS has a lock-in period of only 3 years. It is the shortest across all other investment options. However, investment in equities is meant to be for the long term. Without violating this principle, ELSS gives us super normal returns.

Consider a 15 year period. Investment in PPF will help us get tax deduction only once. For the same period, a five year FD can be reinvested three times. In other words, you get the tax deduction 3 times. When it comes to ELSS, you claim deduction 5 times for the same amount of money for the same period. This further multiplies the effective returns.

To elaborate, if Rs.100,000 is invested on 1st April 2016, the three-year lock-in is completed on 31 March 2019. The investor can simply redeem the units and reinvest the amount on 1st April 2019, again claiming the tax deduction. No other tax-saving product has a lock-in of three or less than 3 years.

4. Remember the Withdrawal is Not Compulsory (so, more compounding)

While the lock-in period for tax saving funds is 3 years, the investor is not forced to take back the money. The investor can simply let the money stay in the fund and grow.

Return from Equity Investments

In our earlier example, we considered the return from a tax-saving fund at 8% p.a. This was done to explain the effect of taxation, keeping the nominal returns equal. However, it is a known fact that return on equity over the long term significantly beats the returns from Fixed deposits or any other interest-earning asset class. All our Jama fund picks under the Tax Blaster category (ELSS) have given returns in excess of 20% p.a. for the 3 year period.

5. Rotate the funds, but tax efficiently

As we discussed before, equity investments are not suitable for short investment periods of 3 years. It is possible that equity markets are in a bear phase and at the time of completion of 3 years, the investor might actually be incurring a loss on his investment in the ELSS. Hence, ELSS should be considered for long term investment.

A little bit of tweaking, by redeeming the earlier units and immediately investing the proceeds into another ELSS, irrespective of gain or loss, ensures two things. Firstly, the investment becomes a long term investment. Secondly, the investor reaps the benefits of tax deduction over and over again. To illustrate, a tax saving fund with a nominal return of 12% p.a. will yield annualized returns of over 28% is retained for a period of 15 years and that is HUGE!!

Update: Do this only if long term capital losses can be offset in such a rotation.

6. Go only for Direct Plans to get another Rs 7,000 Off

Investing via direct plans can help you save up to 6% more due to commissions avoided. That’s a juicy boost to your returns! This could be between Rs 7,000 to Rs 9,000 depending on the fund

Conclusion

So to sum up, ELSS or Tax Saving Mutual Funds are a great way to save tax (up to Rs 46000); they work much better than Fixed Deposits. Continuing the investment or even rotating it out into a different ELSS can give you continued tax savings year after year. Investing via Direct Plans will give you an extra boost!