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Tax Planning for Smarter Investing

Feb 26, 2016 by Priyanka Chakrabarty | 45 Downloaded
Picture courtesy - PICJUMBO

Imagine a situation, where you have been building substantial wealth through your investments. This has brought you closer to your financial goals and you feel excellent about your present and future in terms of finances. While everything is going well, you suddenly find out that you have been paying hefty amounts as taxes. You were so concerned about building your wealth you forgot to take tax benefits into consideration. In this situation, your returns and the process of wealth creation have suffered. A lot of investors do not have to imagine this situation because this is a common phenomenon. Theoretically, tax planning is an integral part of financial planning. A theory that needs to be practiced ensuring that investors can get the most out of their investments.

The current financial year has nearly come to an end. The end of the financial year is always marked with anticipation for the budget. A lot of us wait for some form of benefit or concession in sectors that personally concern us the most. However, a common investor just waits for some more tax concession with a silent prayer that no more taxes are levied on consumer products and the prices remain just the same. While we cannot control any of this, we can always look in to our investments and be a little more effective in our tax planning.

Saving the tax ELSS way

Section 80c of Income Tax Act 1961, lays down various tax exemptions which can be claimed on your Gross Total Income. ELSS, PPF, NSC are the various instruments for tax exemptions. The exemptions under this section suddenly come under scrutiny when the investors have to submit proof of tax savings instruments. In this rush to claim the exemptions, many investors invest in tax saving schemes which might not be beneficial or suitable according to their risk profile and thus get their money locked in for long periods of time. This results in lack of liquidity and also fixed returns obstructing the process of wealth creation while saving taxes.

Equity Linked Saving Scheme or ELSS, as it is popularly known, is that tax saving instrument which allows you to save taxes up to 150,000 and also channelize your investments in Equity and Equity related products. The allocation in Equities can be as high as 100% allowing investors to save taxes and build long term wealth, all in one investment. While there are many tax savings options, ELSS is the only option which gives significant equity exposure. Other options have little or no exposure to equities. ELSS has a lock in period of only three years, which is the shortest lock in period among all options.

How to Invest in ELSS

ELSS investors are always faced with the dilemma whether to invest through systematic invest plan route (SIP) or lump sum route. Lump sums make great investments during bull markets. Investors can make the best of market high as long as the going is good. However, currently we are going through a bearish market phase now. The markets are said to remain volatile. To make the best of the market low and volatility, SIP investments would be an ideal option. However, if you are planning to invest before the end of this financial year then you may want to go for lumpsum investments. For those who are salaried or have regular income and not doing the tax investments at the last moment inclining towards SIPs are the best way. SIPs allow you to earn higher returns through rupee cost averaging and benefits from market volatility. The other reason is no one can predict the market, therefore, why take the risk of investing in one go!

Equity Exposure & Flexibility

Equity exposure is crucial to building wealth. If you are making heavy investments to save taxes and not getting decent post tax returns, it will result in financial losses. Investment in ELSS gives the highest equity exposure. ELSS invests in Equity and Equity related instruments; it is like Diversified Equity Mutual Funds but with tax saving benefits. Equities have been known to be highest return generators among all investment options. Hence, while trying to save taxes it is crucial to keep up with your goals and financial planning as well.

ELSS investments allow flexibility to investors. An investor investing though SIPs can also use lump sum investments to boost their corpus. Lump sums usually come in during bonus pay outs or investment redemptions. During the time of redemption, if you do not wish to redeem all the units, partial redemption can also be exercised. Thus the amount that stays invested continues to give you tax benefits and returns.

Tax Free returns through ELSS

A lot of tax savings instruments allow tax deductions; however, the proceeds from them may not be tax free. There are three categories of tax exemptions:

  • Exempt Exempt Exempt:

    EEE is the best tax saving scheme. Where the initial investment is tax free, any income or long term capital gains are tax free and the total income during withdrawal is tax free.

  • Exempt Exempt Taxed:

    EET implies that the initial investment is tax free, the income or long term capital gains are tax free. The total income during withdrawal is subject to taxation.

  • Exempt Taxed Exempt:

    ETE implies that the initial investments are tax free but the income earned through investments is taxable. However, no taxes are levied during withdrawal of the total amount accumulated.

Comparison of popular tax savings instruments

The table above compares the popular tax savings instruments. It can be seen that Equity Linked Saving Scheme or ELSS turns about to be the best option in terms of tax exemptions and lock in period. Public Provident Fund (PPF) though falls under EEE, it has a very long lock in period of 15 years. The amount accumulated through lump sum or SIPs are tax free, the long term capital gains are not taxable and the total amount accumulated during withdrawal is not taxable as well. However, if you compare the following two charts you will understand that in the long run ELSS generates superior returns than Public Provident Fund (PPF).

Returns generated by investing in Public Provident Fund

Returns generated by investing in Public Provident Fund

The blue line shows the cumulative deposits made by the investor in PPF account every year. The total deposit made by the investor is 15,20,000 ( 15.2 lacs) over the duration of the PPF account . The orange line shows the value of the PPF account, inclusive of accrued interest. The maturity amount of the investor is about 29,82,000 (around 29.8 lacs)

Returns generated by investing in Equity Linked Saving Schemes (ELSS)

Returns generated by investing in Equity Linked Saving Schemes (ELSS)

The blue line shows the cumulative deposits made by the investor in an ELSS Fund (based on our internal research of average returns of Top 10 Performing ELSS funds over 15 years period). The total investment made in the ELSS Scheme from 2000 – 2015, is 15,20,000 ( 15.2 lacs), the same amount deposited in PPF in the previous example. The green line shows the value of the ELSS investment based on prevailing NAVs. As we can see from the chart above, the ELSS returns are of a very different order of magnitude compared to PPF. The value of the ELSS investment as on Feb 2, 2016 is over 1.15 crores, nearly four times the PPF maturity amount.

The other point is that if we take the average inflation of our country from year 2000 – 2015, it has been around 6.80% ( Source - http://www.inflation.eu/inflation-rates/india/historic-inflation/cpi-inflation-india.aspx ) and the CPI fluctuated between 4.02% and 12.11%. So, we may conclude that despite having an assured interest rate and tax free return, the PPF has not done an excellent job and has only beaten the inflation over above years.

Therefore, Investors who wish to have a tax efficient superior return over a long period of time should invest in ELSS Schemes. However, for the investors with low or moderate risk taking appetite investing a portion of their tax saving in PPF can be suggested. But those who are young or have a high risk taking appetite ELSS seems to be the only choice. You may like to read Why is Mutual Fund ELSS the simply best tax saving investment for young investors

The wheel effect of investing in ELSS

Once the lock in period of ELSS investments of three years is over, the capital gains of the first year or capital gains and the initial investment amount can be redeemed. The normal tendency among investors would be to redeem the capital gains and make fresh investments for tax deductions. The wheel effect states that if this amount is circulated back as investments for the next year, then no fresh investments may be required and tax savings will occur the same way. This will create a long term tax saving cycle and reduce the financial burden of have to make fresh investments every year for tax saving. In fact the amount which was kept for investing in tax saving can be invested in other open ended mutual fund schemes. However, the Wheel Effect can be put in place only after three years (Lock-in period) of staying invested in ELSS.


In the rush to save taxes please try avoiding decisions which may have adverse impacts in the long term. For example, selecting a tax saving instrument where you get a fixed return and long lock in period - It means that you will have to make fresh investment every year without being able to enjoy the extra income. It means increased financial burden and lack of liquidity during times of needs. You deserve the most returns that your investments can possibly generate. Hence, apart from investments in PF and EPF usually done through your workplace; give your personal investments equity exposure. Investing in ELSS is like a Swiss knife. One device and many uses - ELSS allows you to save taxes, it provides exposure to Equities, helps you achieve financial goals, provides tax free long term capital gains, tax free dividends and possibly does not require fresh investments after a period of three years if you reinvest the long term capital gains and the initial investment. This financial year give your investment the long needed boost.

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Priyanka Chakrabarty

A literature enthusiast who loves to write. An ardent social worker who dreams of bringing about change and hopes to do so through her writing. A firm believer of the saying pen is mightier than the sword, Priyanka is an English Honours graduate. She also pursed Diploma in Wealth Management Practice from IIFP and is a certified social media expert.

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