June 07 , 2012
What is an equity linked savings scheme (ELSS)?
An equity linked savings scheme (ELSS) is very similar to a diversified fund - it invests in the broad Indian equity market. It has no stated preference for sectors or themes - it chooses stocks based on the fund manager's research and hypotheses. Thus, the stock market indices such as Nifty and Sensex are good benchmarks to compare a diversified fund against.
The one difference is that it has a tax benefit under what is called Section 80C of the Indian Income Tax Act. That means, it is one of the instruments (PPF, Life Insurance schemes, Provident Funds, etc being some of the others) in which investments qualify for tax deduction. In Financial Year 2013-14, the upper limit for tax deduction under all these instruments put together is Rs.1 lakh.
An ELSS has a three-year lock-in period.
Advantages of an ELSS
An ELSS being identical to diversified mutual funds enjoys the same advantages - the general advantages of equities and equity funds (that they yield superior returns over other asset classes in the long term and that they outsource your research work of identifying stocks) apply to ELSS too.
ELSS has the added tax benefit under Section 80C. In Financial Year 2013-14, upto Rs.1 lakh of investment in ELSS and other tax saving schemes is given an income tax deduction. Of all the tax saving instruments available, ELSS has the lowest lock-in period of only three years.
As a tax-saving instrument, an ELSS wins hands down over unit linked and traditional insurance plans since it has far lower costs and charges loaded onto it. Also, a tax-saving instrument is meant for saving for the long term. In long term savings, equity wins comfortably over debt in terms of returns. Thus, ELSS scores over PPF, Provident Fund and 5-year fixed deposits in this regard. This makes it one of the best tax saving instruments available.
Limitations of ELSS
For the purpose of tax savings, there is virtually no limitation of an ELSS. It beats all other tax saving instruments in terms of returns.
Beyond that, you might as well invest in diversified mutual funds rather than ELSS. They give the same benefits, without the three-year lock-in.
Is an ELSS for me?
One of the tax-saving instruments, the Provident Fund, is often deducted straightaway from your CTC before salary is credited to your account. Check how much of this is likely to be credited through the year.
Also, if you have any premiums on life insurance you are paying, add those to the total PF amount. If this total falls short of Rs.1 lakh through the year, you can invest the balance in an ELSS.
How do I choose my ELSS?
Choosing an ELSS is fairly easy, similar to choosing a diversified mutual fund.
But let's first look at how NOT to choose an ELSS. Do not try and time the market while choosing a fund. "Is this the correct time to invest" -is a wrong question to ask. The best way is to spread your ELSS investment through the entire financial year - through 12 systematic investments.
Here's how to choose (the rule of three):
- Avoid funds that have less than three years of track record.
- Avoid funds that have an asset base of less than Rs.300 crore. You can get this figure in the fund fact-sheet (available for download at the fund's site)
- Rank all ELSS in decreasing order of three-year returns. Choose one of the top three. To be sure, past performance may not be repeated in future. Yet, this is the best guide you have - far better than agents peddling their vested interests and half-cooked analysis as 'research'