Do ELSS Funds Still Warrant A Place In Our Portfolios?

Equity is the favourite asset class of almost every Indian investor today. This is even more true when equity exposure is combined with tax benefits. ELSS (Equity Linked Savings Scheme) funds have therefore been loved by the salaried class in India. These are equity mutual funds that come with a 3 year lock in period. They offer a tax deduction under Section 80C of the Income Tax Act 1961, subject to a maximum limit of Rs 1,50,000 per financial year.

But with the new tax regime in place, the relevance of ELSS funds has come into question. Will they continue to be viable investment options going forward? And what would be the way forward for those of us who have already invested in ELSS funds? These are the questions that I will attempt to answer today.

Improper Use Of ELSS Funds

ELSS mutual funds are essentially equity instruments. So they are vehicles for long term wealth creation. But, most Indian investors shift out of ELSS funds when the lock in period expires. So they do not really enjoy the benefits of compounding. This is even more true when ELSS funds are held under the dividend option. Dividends from a mutual fund are an appropriation of the prevailing NAV of the fund. So mutual fund dividends only return a portion of our money back to us. Also, mutual funds can pay dividends even when our investments in the fund are at a loss. More importantly, dividends from mutual funds are taxable in our hands. This repeatedly interrupts the process of compounding, thereby reducing it's benefits.

Irrelevance Of Tax Benefits

Owing to the new tax regime the tax benefits provided by ELSS funds would also become irrelevant. The new tax regime makes more money available in the hands of taxpayers. Therefore, those currently choosing to opt for the old regime would need to be eligible for significant tax deductions. Only then would the old regime be a better fit. This is borne out in the graphic below.

The new tax regime would therefore be the better choice for most individuals. And tax deductions for ELSS funds would not be applicable under the new tax regime. Therefore it would not make sense to invest in ELSS funds just for the tax benefits they offer.

Final Thoughts

In my opinion, we would need to first stop all existing SIPs into ELSS funds. Any lumpsum balance built up in ELSS funds may be held until the lock in period expires. It may then be shifted into regular equity or debt products. This can be done based on our individual risk profiles and desired asset allocation. ELSS funds neither facilitate effective wealth creation nor offer tax benefits that are worthy of note. As an investment option, they therefore retain very little relevance at the present moment.

This may apparently disappoint some investors. But it actually works out to their advantage. Shifting out of ELSS funds opens up a wider variety of options within the universe of equity products. The constraint of a lock in period that is inherent with ELSS funds would also cease to exist. We can expose ourselves to equity products which may be a much better fit for our needs. This would be able facilitate better wealth creation. It would allow us to enjoy tax benefits that are comparable, if not better than those offered by ELSS funds.