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Equity Linked Savings scheme (ELSS)


While tax planning may seem to be a difficult process, Mutual
Funds offer you a simple way to get tax benefits, while aiming to
make the most of the potential of the equity markets.
An Equity Linked Savings Scheme (ELSS) is an open-ended
Equity Mutual Fund that doesnt just help you save tax, but also
gives you an opportunity to grow your money. It qualifies for tax
exemptions under section (u/s) 80C of the Indian Income Tax Act.
Why should you invest in an ELSS?
Along with the tax deductions, an ELSS offers you the following
benefits:
An opportunity to grow your money by investing in the equity
market.
Long-term capital gains from these funds are tax free in your
hands.
The lock-in period is only 3 years. This type of mutual fund has a
lock in period of 3 years from the date of investment. This means
if you start a Systematic Investment Plan in an ELSS, then each
of your investments will be locked in for 3 years from the
respective investment date. Investors can exit ELSS by selling it
after 3 years.

You can also opt for a Dividend Payout option, thereby realizing
some potential gain during the lock-in period.#
You can invest through a Systematic Investment Plan and bring
discipline to your tax planning
Similar to other equity funds, ELSS funds have both dividend and
growth options. Investors get a lump sum on the expiry of 3 years
in growth schemes.
On the other hand, in a dividend scheme, investors get a regular
dividend income, whenever dividend is declared by the fund, even
during the lock-in period.
For tax purposes, returns from an ELSS scheme are tax free. You
can claim upto Rs. 1 lakh of your ELSS investment as a deduction
from your gross total income in a financial year under Sec 80C of
the Income Tax Act.
Key points to remember
A Equity linked savings schemes is a type of mutual fund with 3
years lock in period and tax benefits attached,
B - There are three types of options in ELSS, dividend option
growth option and dividend reinvestment option.
C Tax benefits on investment in ELSS may soon be phased out
with the introduction of direct tax code.

D Investors can opt for systematic investment plan. Minimum


investment required in SIP is Rs 500. An investment through SIP
has a disadvantage as every monthly investment carries a lock in
period.
E - If an investor chooses dividend reinvestment plan the dividend
reinvested is considered as a fresh purchase and has a lock in
period of 3 years from the date of purchase so the dividend
reinvested is further locked for a period of 3 years.

Criterias to chose ELSS


a)
AUM Asset under management is the amount of money
the fund is managing. Higher AUM implies that the fund has many
investors and has a good reputation.
b)
Past performance If the fund is performing well in the
past, it is expected that the fund will keep performing well in the
future. Generally we look at the past 3 yrs 5 yrs and 10 yrs return
of the fund.

F ELSS has the potential to give higher returns as these funds


invest in equity market which have given an average return of 15
years in a long term scenario. Returns in ELSS also fluctuate
depending upon the stock selection decision of the fund manager.

c)
Sharpe ratio Sharpe ratio is used to calculate risk factor
of the funds portfolio. Sharpe ratio of the fund should be near 1.

G SIP helps in averaging out the cost of investors, however if


the investor backs out from SIP when the markets are falling he
wont be able to average out his cost.

Features of ELSS and other Tax Saving instruments u/s 80C


of Income Tax Act, 1961

# However, it must be noted that any dividend payment will be


from the NAV of the Scheme and therefore the NAV of the scheme
will fall to the extent of dividend payment. Also dividend payment
is subject to availability of distributable surplus and approval from
Trustees.

Particulars
PPF
Tenure
15 years

Returns

Minimum
Investment
Maximum

8.70 % *
(Compounded
Annually)

NSC
6 years

ELSS
3 years
Returns /
8.50 to 8.80 %
Dividends are
*
Market
(Compounded
linked and not
half-yearly)
assured

Rs.500

Rs.100

Rs.500

Rs.150,000

No limit^

No limit^

Investment
Amount
eligible for
Rs.150,000
deduction u/s
80C
Taxation for
interest
Safety/ Risk

Tax free

Rs.150,000

Rs.150,000

Dividends and
Taxable
capital gain
tax free
Highest Safety High Risk

Highest Safety
15 Years - Partial
Lock-in Period Withdrawal after 6 6 Years
years is permitted

3 years

Mutual funds Vs ELSS


a.
Tax Free: - There is no ceiling for investments in ELSS
however investments in ELSS qualify for tax deductions under sec
80C of the income tax act subject to a maximum of Rs 100000 in
a financial year whereas investments under normal mutual fund
do not qualify for income tax deductions. Any dividend received or
long term capital gain earned by the investor is tax free. Long term
capital gain arises on selling units of mutual fund after 1 year of
purchase. Since there is a lock in period of 3 years every investor
will realize long term capital gain/loss on selling their holdings
b.
Lock In: - ELSS has a lock in period of 3 years unlike
other kinds of mutual funds.
Will you get assured returns?
Since these are essentially diversified mutual funds, there is no
guarantee on returns. The ELSS category has given an average
return of 2.95% in the past five years. The best performing fund
increased an investment of Rs 10,000 to Rs 16,519 during this
period, but the worst performing scheme reduced it to Rs 5,991.
In the past three years, the average return has been 6.82%, while
the best performing fund has given 13.5%. So, apart from the
performance of the broader market, your returns are dependent
on the fund manager's ability to pick the right stocks. This also

means you must select the fund after proper research. Instead of
picking a fund with high, but volatile, returns, choose one with a
stable performance record.
What's the lock-in period?
The lock-in period is only three years, the shortest among all taxsaving options under Section 80C. You cannot redeem or switch
to another option during this period. In the case of SIPs, each
instalment is treated as a separate investment and will have a
three-year lock-in period. So, if you started investing in an ELSS
fund in April 2010, you can redeem the units bought in the first
instalment only in April this year.
Those bought in May 2010 will be open for redemption only in
May. The lock-in stipulation does not mean that the investor must
compulsorily redeem the funds after three years. Unlike Ulips and
pension plans, there is no maturity date of an ELSS fund. If you
want, you can remain invested for a longer period. 4) Dividend,
growth or reinvestment?
The dividend is only a profit-booking exercise since a fund's NAV
reduces by the amount the investor receives as dividend. In the
growth option, the amount remains invested for the entire tenure.

The dividend option provides a periodic income to the investor,


though there is no obligation on the part of the mutual fund to
declare a dividend or maintain its payout ratio year after year. The
growth option has the potential to generate higher returns. Your
choice should depend on your needs and risk appetite. Avoid the
dividend reinvestment option because you will find it difficult to exit
the fund completely. There will always be some units that have not
completed the lock-in period.
How should you invest?
Unlike regular equity schemes, the ELSS funds have a lower
investment threshold of Rs 500. You can invest a large amount at
one go, but the best way to invest in equity-oriented instruments is
through regular monthly driblets called SIPs.
For instance, if you have Rs 30,000 to invest in ELSS funds this
year, split them into three instalments between now and 31 March.
This will curtail the risk significantly by averaging out your cost of
purchase. To start an SIP, submit post-dated cheques or give an
ECS mandate to your bank. The money will be automatically
transferred to your mutual fund every month.

ELSS as Tax saver


Equity-linked saving schemes (ELSS) have the shortest lock-in
period of three years among all the tax-saving options under
Section 80C. However, this should not be the most important
reason for investing in this avenue. Being equity funds, these
schemes can generate good returns for investors over the long
term. In the past five years, this category has created wealth for
investors with average returns of 17.5 per cent.
However, this potential to earn high returns comes with a higher
risk. There is no guarantee that your investment will generate
positive returns after the 3-year lock-in period. The category has
generated an average return of 2 per cent in the past three years.
Even the best performing funds have churned out disappointing
returns. The returns will naturally mirror the performance of the
stock markets. Therefore, only investors who have the stomach
for a roller-coaster ride should consider this option.
Should investors avoid ELSS now, especially since the stock
market is close to its all-time high? Not really, because the stock
market has returned to the previous high after a 6-year gap and,
therefore, is not overvalued at all. "Since the stock market is
reasonably valued now, ELSS should generate good returns for
investors who can remain invested for 5-7 years," says Gajendra
Kothari, managing director and CEO, Etica Wealth Management.
Though the large-cap Sensex and Nifty are at higher levels, the
mid-cap and small-cap indices are at much lower levels. This
means there is enough value in midcap stocks, which should help

the fund managers do well in the coming years. Selecting the right
scheme is crucial since there is significant variation in the returns
of different schemes.
Though past performance is an important parameter, also take
into account the track record of the fund house and fund manager.
Once you select a scheme, decide whether you want to go for the
dividend or growth option. There is no difference in the tax
treatment of the two options. The decision should be based on the
cash-flow requirements of the investor. If you opt for the dividend
option of the fund, you might get some portion of the money back
within 1-2 months. Dividends from mutual funds are tax-free so
there is no tax liability as well. Avoid the dividend reinvestment
option for ELSS schemes because the lock-in period will prevent
you from exiting fully.
Though the ELSS funds invest in equities, they are different from
other open-ended diversified equity funds. Due to the lock-in
period, the ELSS fund manager does not have to worry about
redemption pressure from investors. This gives him the freedom to
invest in shares as per his conviction and hold them for longer
periods.
In the past few years, the ELSS category has consistently
outperformed the large and midcap sub-category of diversified
equity funds (see graphic).

ELSS funds offer tremendous flexibility to investors. As mentioned


earlier, the 3-year lock-in period is the shortest. Since there is no
tax on gains from equity funds after a year, an investor can safely
recycle his investments every three years and claim tax benefits
on the reinvested amount.
Young taxpayers, who have taken huge loans and don't have
enough surplus to save tax, will find these schemes very useful. If
you can help it, don't exit the scheme after three years just
because lock-in period is over. Studies show that equities give
better returns in the long term. The minimum investment is also
very low.
Though regular equity mutual funds have a minimum investment
of Rs 5,000, you can put in as little as Rs 500 in an ELSS

scheme. Unlike a Ulip, pension plan or an insurance policy, there


is no compulsion to continue investments in subsequent years.
Since ELSS funds are a high-risk investment and their NAVs are
volatile, you need to stagger your investment over a period of time
instead of going for a lump-sum investment at the end of the
financial year. This is more important at this juncture when the
benchmark indices are trading close to their all-time high levels.
Your best option is to take the SIP route. This may not be possible
now because you have less than three months before the 31
March deadline. At best, you can split the investment into three
tranches. Before you take the plunge, remember that your
investment should be guided by your overall asset allocation. If
your exposure to equities is lower than what you want, go for the
ELSS fund. If your portfolio already has too much equity, avoid
investing in these funds.

Points to remember while choosing an appropriate ELSS


You must always remember to do thorough research when you
invest in an ELSS fund. You must look at the long term
performance of the fund before putting your money in it. Also
remember to look at the fund details like the fund managers
investment approach, portfolio of the fund, the expense ratio of
the fund and how volatile the fund has been in the past.
Mutual Fund investments are subject to market risks, read all
scheme related documents carefully.

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