ELSS Versus Other Tax Saving Options

Under Indian tax laws, savers have a complete range of tax saving instruments like Public Provident Fund (PPF), Tax-saving fixed deposits, National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS) and others. Yet, individuals often take sub-optimal investment decisions with their tax-saving investments. Why does this happen?

One common reason is that there is a confusion of goals between saving tax and making investments. The typical investor makes this decision either in late March under the duress of having the deadline slip by, or under pressure by a salesperson who drives home the fact that time is running out. The pressure may intensify if the salesperson is a relative or a friend. At the end of the day, we make sub-optimal investment decisions and when we realise the fact later, we console ourselves by saying that at least we got tax benefits for the investments. This approach proves expensive in the long run.

This dual concern prevents clear-headed thinking about just exactly what one is getting out of an investment and whether the quantum of disadvantages are actually worth the quantum of tax benefits that are being obtained. Investors should work on eliminating both these sources of poor decision-making-time pressure as well as not thinking through about these investments. Eliminating time pressure is simple. Just plan these investments as early in the year as possible and once you start in time, there's no need to stop after a year.

For most people, the investment that should make most sense is an ELSS. Salary-earners generally have some of the permitted amount going into fixed income through PF deductions. And, to balance that, equity is advisable. ELSS is unique in being the only viable tax-saving investment within Rs 1.5 lakh limit that brings the benefits of equity returns. Sure, there are two other options that give equity-linked returns - ULIPs and the National Pension System (NPS). However, ULIPs have a longer lock-in period of 5 years, coupled with high costs and poor transparency. The NPS is a retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age. There's no way a three year lock-in product like the ELSS can be compared to the NPS.

For many beginner investors, it makes an excellent gateway product in which they get the first taste of equity investing and of mutual funds. You end up investing in these funds because the tax-saving attracts you and it has the shortest lock-in. This experience encourages investors to invest in equity mutual funds over and above their tax-saving needs. Once you get used to long-term equity returns, you end up trying other types of equity investments as well.

Equity investment carry higher risk over the short-term. However, for investment periods of five years or more, the risk on equity investments is considerably lower. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation. Like all equity investments, the best way of investing in an ELSS is through monthly SIPs throughout the year. SIP also gives the dual advantage of avoiding any last minute rush. At the beginning of every year, estimate the amount you have left over from the Rs 1.5 lakh limit after statutory deductions, divide it by 12 and start an SIP. Simple.