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How does an ELSS Fund combine the best of both worlds?

An Equity Linked Saving Scheme (ELSS) is an equity mutual fund with a tax benefit on investment. But there are some additional benefits on the ELSS scheme that may not be immediately apparent. When we talk of tax benefits here we need to understand the tax benefit as distinct from the tax benefits on dividend and capital gains. Currently, dividends paid out by equity mutual funds are entirely tax free in the hands of the investor. Where ELSS scores over other equity funds is in the special tax exemption under Section 80C.
Deciphering the provisions of Section 80C for ELSS..
Section 80C is a special exemption given to tax payers up to a limit of Rs.150,000 per annum. This section, however, includes a lot other items. Section 80C includes your payment of LIC premium, contribution to provident fund, payment of tuition fees for your children, principal repayment on your home loan and long term bank FDs among other things. A key inclusion in Section 80C is the Equity Linked Savings Scheme (ELSS). This is like any other equity mutual fund with the only difference being that there is a compulsory lock-in of 3 years from the date of the investment. These units cannot be redeemed before the completion of 3 years. ELSS is also included under Section 80C and the exemption limit of Rs.150,000 is applicable to all the items mentioned above combined. What is important here is that the tax exemption under Section 80C substantially enhances the effective post-tax yield on an ELSS as compared to a normal equity fund.
Benefit 1: How ELSS enhances the effective yield for the investor..
To understand the tax implication of the ELSS, let us look at the case of a two investors who invest the same amount of money in an equity fund and in an ELSS fund.

Investor A (Equity Fund)AmountInvestor B ( ELSS Fund)Amount

Investment amount100,000Investment amount100,000Value at the end of 3 years175,000Value at the end of 3 years175,000Profit in INR75,000Profit in INR75,000Total Returns over 3 years75%Total Returns over 3 years75%CAGR Returns20.6%CAGR Returns20.6%Effective Returns after considering Section 80C benefitsExemption u/s 80C-Exemption u/s 80C30,000Effective Investment in T1100,000Effective Investment in T170,000Revised CAGR Returns after considering Section 80C20.6%Revised CAGR Returns after considering Section 80C35.8%. Explore the CAGR Calculator and get deeper insights take help from ELSS Calculator and calculate your funds manually.

The above table clearly captures the huge difference that the Section 80C rebate offers to Investor B. Remember, Investor B gets a 30% tax rebate in the year of investment which effectively reduces Investor B’s outlay to Rs.70,000. This makes a massive difference to the CAGR returns over 3 years, although both the funds have performed similarly. That is the power of an ELSS as it offers an effective yield after considering the tax shields.
Benefit 2: ELSS fund managers take a long term view..
We have already seen how the tax shield makes a huge difference to the effective yield of the investor. In the above case, Investor B earns 35.8% CAGR returns on ELSS over 3 years compared to 20.6% CAGR returns for a normal equity fund. This difference is on account of the tax shield on Section 80C. There is another major advantage that ELSS has. Firstly, from an investor’s point of view, it not only saves tax but also forces you take a long term view of investing. This is due to the compulsory 3-year lock-in. This has an additional advantage. Quite often, fund managers in equity funds have the tendency to churn quite often due to pressure to book profits and keep the MTM position as favourable as possible. When investors are locked in for 3 years, the fund manager is also assured of the longevity of the investor. This induces the fund manager also to take a long-term view of investing. That has normally worked in favour of the ELSS funds in India. It also explains why ELSS funds, even in absolute terms, have tended to outperform pure equity funds.
Let us not forget about rupee cost averaging (RCA)
It is recommended that even an ELSS should be done through the SIP route. Firstly, it helps you to match your outflows with your inflows and forces you to start planning taxes in a systematic manner rather than bunching it at the end of the year. Secondly, it gives the benefit of RCA, which implies that you get better value when the NAV goes up and you get more units when the NAV goes down. There is also a third advantage in adopting the SIP route. Your 3-year lock in commences from the date investment. Hence an ELSS SIP is better than bunching your ELSS investment at the end of the year.
ELSS has emerged as an ideal source of tax planning. You get the benefits of enhanced yields combined with long term wealth creation. Surely, a case of getting the best of both worlds!

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