As we approach the last quarter of this financial year, chances are that you have seen multiple advertisements promoting ELSS funds and why you should invest in them. While investing in ELSS funds is definitely a good idea for many investors, a lot of this marketing goes overboard in selling you the idea that ELSS funds are the best investment you can make. A large part of this has to do with the fact that your distributor will earn fat commissions if you buy ELSS funds irrespective of whether it is the right investment for you or not.
In this article, we aim to demystify ELSS funds and who are these funds suitable for. With our 3 question checklist, you can make an informed decision on whether this is the right investment for you or not.
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What are ELSS funds?
What is special about ELSS funds?
Any investment in ELSS equity funds is exempt from income tax under Section 80C of the Income Tax Act. So it can be deducted from your income before calculating taxes. This is subject to a cap of Rs 1.5 lakh on the investment amount. So if you are somebody in the 30% tax bracket (taxable income above 10 lakhs) then you can save Rs 45,000 (= 30%*1.5lakhs and excluding education cess) by investing Rs 1.5 lakh in ELSS funds. For those in the 20% and 10% tax brackets, they can save Rs 30,000 and Rs 15,000 respectively. To enjoy this tax benefit, there is also a lock-in of 3 years. During this period any gains are tax-free and the withdrawal amount after 3 years is also tax-free. Aa result ELSS is classified as an EEE investment – Exemption from tax of investment amount, Exemption from tax of gains and Exemption from tax of withdrawal amount.
Should you invest in ELSS funds?
#1: Do you have any investment limit left under Section 80C?
Our research shows that the performance of ELSS funds is pretty much in line with that of other non-ELSS equity funds. Hence if you are already exhausting your 80C limit through other expenditures then it does not make sense to invest in ELSS funds since you will have an unnecessary 3 year lock-in period which does not exist with other equity funds. Gains on equity funds are as it is tax-exempt after 1-year investment.
#2: Are you willing to say invested for the long term?
I have seen many ELSS ads touting the twin benefits of high expected returns (~15%) and low lock-in period (3 years) compared to other 80C investment options. However, this is misleading. Unless you turn out to be quite lucky in terms of timing your investment, you may not be able to enjoy both of these benefits. Performance of equities and consequently equity funds is notoriously difficult to predict. Equities have the potential to give double-digit returns over the long-term (say 7+ years) but performance can vary a lot from one year to next and even over 3 year periods.
Hence you should consider investing entirely in ELSS funds only if you have an investment horizon of 7+ years. For investment horizons between 3 and 7 years, you should consider investing in some combination of interest-paying debt investments eligible under Section 80C and ELSS. Even though your expected returns will be lesser, you will have a much higher probability of getting positive returns at the end of your investment horizon.
One thing that I would like to add here is that apart from ELSS, the two other 80C investments which are also EEE (and hence are the most beneficial) are PPF and Sukanya Samriddhi. Unlike ELSS, both are fixed return investments but you can only invest in them if you have a long investment horizon since they have long lock-in periods of 15 years and 21 years respectively. As a result, to get the maximum benefit from your 80C investments it is recommended that you should use the 80C bucket for long-term goals like retirement. This way you can invest unhindered in the EEE investments such as ELSS and PPF and get the maximum tax benefit.