economics

January 19, 2010

Things to know before investing in Tax Saving Funds

Filed under: Uncategorized — ktetaichinh @ 11:52 pm
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Equity Linked Saving Schemes (ELSS) or tax saving mutual fund schemes as they are otherwise known as, are a popular tax saving investment. The major reason for this popularity has been the introduction of Section 80C of the Income Tax Act, from April 1, 2005. This section allows the investor to invest up to Rs 1 lakh in various investment products and get a tax deduction for the same. The list of investment products also includes ELSS. Earlier, till March 31, 2005, investment in these tax saving schemes only allowed for a tax deduction of up to Rs 10,000 under Section 88.

However, that being said, there are various things an investor needs to keep in mind before deciding to jump into an ELSS investment.

  1. Section 80 C spoils you for choice: As has been mentioned above, ELSS is not the only investment avenue that comes under Section 80C. Other investments such as Life Insurance, Public Provident Fund (PPF), National Savings Certificates (NSCs), Senior Citizen Savings Scheme (SCSS), Post Office Monthly Income Scheme (POMIS) etc also offer a similar tax benefit. Then there are mandatory payments such as your PF, tuition fees of children and even housing loan repayments that are covered under Sec. 80C. Let us say an individual contributes Rs 40,000 to the PPF every year and Rs 30,000 is his provident fund deduction. So for him it makes sense to invest only the remaining Rs 30,000 [Rs 1 lakh – (Rs 40,000 + Rs 30,000) = Rs 30,000] for tax deduction under Sec. 80C. This is primarily because if he invests more than Rs 30,000, he will cross the overall level of Rs 1 lakh and the deduction is limited to Rs 1 lakh.
  2. Lock-in of three years: Like all investment avenues under Section 80C, ELSS funds also involve a certain lock in. In this case the lock in is for three years. Hence an ELSS investment cannot be withdrawn for a period of three years from the date of investment. This lock-in is like a double-edged sword. On the one hand, it fosters long-term investment, which is very essential while investing in equity. And on the other, if you find yourself in a situation where you require funds in an emergency, you will have to resort to other means / investments — the ELSS fund will be closed to you for three years. Withdrawals are just not allowed, not even with a penalty.
  3. Tax saving schemes carry the risk of investing in equity: ELSS funds are promoted as good investments as they enable the fund manager to take long-term calls on account of the enforced three year lock-in. In other words, the fund manager doesn’t have to worry about keeping funds liquid to cater to daily redemptions that can happen in normal open ended schemes. However, it has to be kept in mind that ELSS funds for all practical purposes are similar to normal diversified equity mutual fund schemes. The funds in these schemes are invested in the stock market. Hence the returns these schemes generate depend on the kind of stocks the fund manager invests in and the overall state of the market. So if an investor invests in a tax saving scheme, and three years down the line, when the lock-in ends and the markets are not doing well, his total returns will take a beating. Yes, this has not happened in the past as the Indian market is in a lateral bull phase (barring the occasional hiccups). However, the potential of capital loss is very much there and it has to be considered. So investors need to consider their risk taking ability in terms of age and responsibility before deciding on investing in ELSS.

The bottom line? Whether ELSS or any other investment, do not invest because the investment offers a tax benefit. Ask yourself whether you would have invested in the particular instrument per se — the tax benefit should be the incidental icing on the cake. This will ensure that all your investments will be as per your risk profile and goal oriented and not only on for the temporary purpose of saving tax.

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