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ELSS versus long term tax-free fixed deposits

07 Aug 2023

What is the best way for individuals to save tax? The Income Tax Act offers a variety of instruments that individuals can invest in including PPF, EPF, insurance premium etc. Within the gamut of Section 80C, there are two interesting instruments viz. the Long-Term FD and the ELSS. While both these instruments are covered within the overall limit of Rs. 150,000 per annum exemption, the question is what should tax payers actually choose?
Understanding the LTFD versus the ELSS debate
A long-term FD is like any other fixed deposit issued by a scheduled commercial bank. Bank FDs come in different maturities starting at 1-year maturity and going higher. A few years back, the Income Tax Act permitted 5-year FDs to be included within the ambit of Section 80C. A person who invests in a 5-year FD can claim benefits under Section 80C for the quantum of the investment. However, such investments cannot be encashed during the tenure of the FD. Any such breakage of the FD will result in the entire tax exemption being withdrawn and that amount will be added to the income of the individual in the year in which the FD is broken. However, the rate paid on such FDs is slightly lower than the normal FD rate of interest to factor in the benefits of tax exemption on them.
Equity Linked Savings Schemes (ELSS) are a form of equity mutual fund with a compulsory lock in of 3 years. The benefit of Section 80C is similar to what you would get in case of any Section 80C product. Like in case of long term FD, the ELSS also cannot be broken. The question, therefore, is what should individuals prefer?
Evaluating the lock-in period
On this aspect, the ELSS has a clear advantage. While the long-term FD has a lock-in period of 5 years, the ELSS has a lock-in period of only 3 years. This allows the individual to churn the funds quicker and actually use the same to claim the Section 80C benefit twice within the period of 5 years. That puts ELSS at an advantage over the long-term FDs. Of course, in both the cases not holding the instrument for the full tenure results in cancellation of the exemption. Comparatively, the ELSS appears to be a better bet from the liquidity perspective.
Evaluating the risk factor..
If you were to purely look on the scale of risk, the bank FD is less risky compared to an ELSS. Before making a choice, consider the risks and rewards as ELSS has the potential for better profits. You can use an FD calculator to determine the interest rate you will receive on a bank FD and an ELSS calculator to determine the potential growth of your investment. An ELSS is after all, an investment in equities and hence carry all the risks that go with equities. Additionally, the ELSS also entails the intermediation risk of fund managers taking wrong decisions. To that extent, the bank FD is on a lower risk scale. However, risk needs to be looked in a slightly broader context. For example, the bank FD does not participate in changes in interest rates, the way a debt mutual fund does. Also, the bank FD lacks the transparency on the end use of money, which is not the case in an ELSS where the entire portfolio is disclosed transparently.

Evaluation of wealth creation capabilities
This is where the ELSS actually scores over the bank FD. Over the past few years, the rates on bank FDs have been on a consistent downtrend due to lower rates announced by the RBI. As mentioned earlier, investors in bank FDs tend to lose out vis-à-vis debt funds as they do not participate in the capital appreciation of debt instruments as in the case of debt funds. ELSS funds have a couple of unique advantages. Firstly, equity funds have tended to consistently outperform the index over a longer period of time.  Secondly, the lock-in period of 3 years works in favour of ELSS funds as fund managers of these funds tend to churn less and adopt a more long-term view of equities. Over the longer period of time, ELSS actually tends to generate wealth for investors.
The choice for individuals is quite clear. If your intent is to save tax and also create wealth in a tax-efficient manner, then ELSS could be the right product for you. Of course, you have the risk of equities that is implicit in ELSS funds. But then in the current market conditions; not taking any risk can be the biggest risk for investors!

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