Heard this great saying by former US President Richard Nixon? “Make sure you pay your taxes; otherwise you can get in a lot of trouble.” Sampath a young 28 year old man, works in an IT firm in Bengaluru. He had never heard of Richard Nixon, but he knew he had to pay taxes.
Sampath earned Rs 12 Lakhs a year. This salary meant he paid a lot in taxes, as he never bothered to do tax planning. He grumbled, he cursed, but he paid his taxes. All this changed the day a friend introduced him to mutual funds, or more specifically a type of mutual fund called Equity Linked Mutual Funds or ELSS. His friend also told him something he would remember all his life, “A rupee saved is a rupee earned.”
ELSS is an equity diversified mutual fund which invests most of your money in stocks across sectors. An investment in stocks is risky, but investing across sectors called diversification, offers a measure of protection. ELSS has a compulsory lock-in period of 3 years. This means you can’t touch the investment for this time.
Sampath had another problem. Where to invest? He had some money in fixed deposits. Fixed deposits offered decent interest, but you can never get rich, just by investing in FDs.
You must be having a lot of questions, the first one being, how does ELSS save tax? You enjoy the Section 80C deduction up to Rs 1.5 Lakhs a year. ELSS is the only mutual fund which enjoys this benefit. There’s a 10% long term capital gains tax (LTCG) on capital gains exceeding Rs 1 Lakh a year.
ELSS is an excellent investment if you fall in the higher tax brackets. Sampath earned Rs 12 Lakhs a year which put him in the 30% tax bracket. ELSS saved Sampath Rs 46,800 a year.
Sampath invested Rs 1.5 Lakhs a year in ELSS. Now 30% of Rs 1,50,000 is Rs 45,000. Add a cess of 4% on income tax of Rs 45,000 which translates to Rs 1,800. Sampath saves Rs 46,800 a year by investing in ELSS.
He enjoys the highest returns among Section 80C options with the lowest lock-in. Sampath chooses the best way of investing in ELSS which is through SIPs.
ELSS invests most of the money in stocks. Doesn’t this make it a risky investment? Any investment involves risk. Even FDs are risky as a part of the interest you earn is swallowed by inflation. Equity investments offer high returns at high risk. The key is to stay invested for the long term and cut risk in investment.
ELSS is an excellent investment for a young man like Sampath. He doesn’t have many responsibilities and can stay invested for the long term. This makes ELSS an excellent investment for many youth in India.
Now to the second question. How does investing in ELSS make you rich? Ever heard of compounding returns? Compounding returns are return on return. The returns you get are reinvested to give more returns. Find this difficult to understand?
Let’s see how much Sampath has if he retires at 60, having invested just Rs 8,000 a month in ELSS via SIPs. Sampath has 32 years left till retirement. Let’s assume a conservative return of just 9%. Sampath would have built around Rs 1.77 Crores at retirement from this SIP. Looks a massive amount. Sadly, Sampath will have much less at retirement. Inflation eats up a lot of his returns and if you assume an average inflation of 5% over the period, Sampath will have only Rs 60 Lakhs at retirement.
Here’s the good news. ELSS can give average returns of 12-14% over 3 years and 15-17% over 5 years, depending on the type of ELSS. This is nearly double the returns most conservative investments offer. The longer you stay invested, greater are the returns. The power of compounding ensures you are a Crorepathi at retirement.
ELSS saves tax and makes you rich. You can save Rs 46,800 a year on being in the highest tax bracket. This amount when invested in the ELSS gives returns much above inflation. ELSS combines the double benefits of tax saving and compounding returns to make you rich at retirement.