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Tax Planning: using ELSS in smarter way

Last 14 days left before closing of financial year 2010-11. Most of you must have invested for Tax saving in last 1-2 months only. Tax saving is a different from Tax planning, because in Tax planning you make the investments in a preplanned manner to generate the optimum results with minimum risks. In this article we will try to understand the importance of Tax planning vs. Tax saving. As in the last few articles, we discussed about various instruments to save our tax and I always emphasized on the correct allocation to different instruments available. One of the important instruments is ELSS, which our young generation is using extensively to generate better returns.

ELSS – Equity Linked saving schemes are the tax saving MFs run by various fund management companies. When I suggest to my colleagues, elders or customers about these options there are two extreme reactions which I received;

  • Are you mad? They are very risky investments. I invested in one ELSS scheme and now even after 3 yrs my money is less than my investment. If I consider high inflation my money has gone negative. No way never invest in them.
  • This looks great option to invest. Annualized return for last 2 yrs or 1 yr which all Funds quote is almost 40-50% per year. I am going to invest all my money in these schemes.

Unfortunately both of the reactions are wrong. As the famous financial investment Guru Benjamin Graham says “The fault, dear investor, is not in our stars—and not in our stocks—but in ourselves.” Let us understand why he was right and both of the above reactions are wrong because of our psychology and experiences.

 First, Let us understand what is ELSS?

These are mutual fund schemes, which are 100% diversified equity funds providing tax benefits. And these are popularly known as Tax Saving Mutual Funds. A distinguishing feature about them is that they are subject to a compulsory lock-in period of three years, but the minimum amount in most of them is as little as ` 500, with no upper limit. You can either make lump sum investments or investments through the Systematic Investment Plan (SIP).

What is SIP?

SIP-Systematic investment plan is the option to invest small regular amount in a particular fund. For e.g. If you want to invest 48000 in ELSS in a year then instead of depositing in one go Lump sum, you can opt for SIP. Different SIP options are available like monthly, quarterly, half-yearly and money will deduct from your account as per the choice and invested.  

What are the tax benefits on these investments?

The maximum tax benefit which you can enjoy is INR 1,00,000 p.a. under section 80C. So depending on your tax bracket, you get save tax ranging from INR 10,000 to INR 30,000. Moreover, if you make any long-term gains at the time of exit any time after the end of the lock-in period; then you would not have to pay any Long Term Capital Gains Tax (LTCG) too.

Now let us come back to the two extreme views and understand the reality;

Are you mad? They are very risky investments. I invested in one ELSS scheme and now even after 3 yrs my money is less than my investment. If I consider high inflation my money has gone negative. No way never invest in them.

Yes, you may say – “but there is risk involved”. Well, no doubt about that, but in order to even out the shocks of market you can adopt the SIP route of investing here which will provide you the advantage of “compounding” along with “rupee-cost averaging”.

Let me simplify, when we invest through SIP during volatile markets our investment cost also goes down. Hence we are able to generate the better returns comparing to the situation when we invest in lump sum. In following chart we can see the returns on different schemes for last 3 yrs as market has fallen drastically.

The returns on SIP were on an average around 18-22% while for lum sum investments been just 0-2%. This shows that we are able to generate moderate return even when the market has gone down by huge margins and people are losing money on their investments.  

This looks great option to invest. Annualized return for last 2 yrs or 1 yr which all Funds quote is almost 40-50% per year. I am going to invest all my money in these schemes in lump sum.

This is second common mistake people do because most of the companies quote:

  1. Highest return they generated in last 1-2 yr to impress their customers
  2. Clause: Investments are subjected to market risk
  3. Sales person generates more on big investment amounts than small SIP

Below chart shows, why returns are better on Lump sum investments than SIP when market is doing good;

 

We generate average 25-35% on SIP while in Lump sum we get extra-ordinary 40-55% returns. The most important part is through SIP we get more stable returns and investment amounts are so small that you never feel the pressure to invest large amount on short notice or urgently for tax saving.

That is why I suggest to do Tax planning and to start a SIP of a good ELSS fund from the start of financial year. Keep reading to know about how to select funds for investments.

“HAPPY INVESTING”

2 thoughts on “Tax Planning: using ELSS in smarter way”

  1. Which ELSS are currently the best offered in the market?

    And what will you suggest given the current market conditions, a SIP or lumpsum?
    I want to invest around 30000 rupees
    Thanks

    1. In the current market situation, Market is expected to fall because most of the macro economic factors are working against it. So better way is to start SIP only. As you want to invest 30,000 in this year then make an SIP of 3000 pm.

      the suggested funds will be Franklin India Tax shield and HDFC Tax Saver, As both of them give consistent return over the period of time and their volatility compared to other funds is very low.

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