Equity as an asset class has become the darling of almost every Indian investor today. And when exposure to equity is combined with the element of tax saving, it only sweetens the deal that much more. ELSS (Equity Linked Savings Schemes) funds have therefore been a hot favourite amongst Indians, especially the salaried class. These are equity mutual funds that come with a 3 year lock in period and provide investors the benefit of 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 proposals of the recently announced Union Budget for 2023 making the new tax regime the default option for all taxpayers, and the government pressing ahead with its intention to phase out the old tax regime completely over the next few years, the relevance of ELSS funds has come into question. Will they continue to be viable investment option going forward even if they were to stop providing the tax benefits they have until now? 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.
ELSS mutual funds are essentially equity instruments, and therefore are vehicles for long term wealth creation. But, most Indian investors have traditionally show a tendency to recycle any money invested in ELSS funds post the expiry of the lock in period of 3 years by redeeming from their ELSS funds and shifting that money somewhere else. So they essentially do not harness the benefits of compounding effectively. There would definitely be a few investors who hold ELSS funds for considerable periods of time. But even they cannot enjoy the benefits of true compounding.
This is because most ELSS funds pay out dividends regularly. Now, dividends from a mutual fund come at the cost a reduction in the prevailing NAV of the fund. So all a mutual fund does when distributing dividend is return a portion of our money and income 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. Most investors would therefore be better served shifting their money from ELSS funds to more traditional variants of equity mutual funds, such as a large cap index fund.
In the wake of the changes to the new tax regime effective from 1st April 2023, the tax benefits provided by ELSS funds would also become increasingly irrelevant. To begin with, the new tax regime has made more money available in the hands of taxpayers. This is achieved mainly through an increase in the basic exemption limit from Rs 2.5 lakh to Rs 3 lakh, and an increase of the rebate under Section 87A from Rs 12,500 to Rs 25,000, effectively exempting net taxable income upto Rs 7 lakh from tax every financial year. Slab rates under the new regime are also lower relative to the old regime.
Therefore, those currently choosing to opt for the old regime would need to be eligible for significant tax deductions outside of those available under Section 80C, 80D and 80CCD(2) such as home loan interest and HRA to ensure that they continue to pay lesser taxes under the old regime relative to the new regime. And it is very rare for the same individual to be able claim considerable deductions under both these heads. I have discussed the nuances of this aspect in an earlier piece Taxes And Messages Post Budget 2023. Ultimately, it must be borne in mind that the old tax regime would be gradually phased out and everyone would be taxed exclusively under the new regime, where tax deductions for ELSS funds would not be applicable.
Therefore it would not make much sense to invest in ELSS funds just for the tax benefits they offer. That leaves the question as to what those who currently hold ELSS funds in their portfolios should do with their holdings. In my opinion, it would be for almost all of us to opt for the new tax regime right from today. After this, we would need to first stop all existing SIPs into ELSS funds. Any lumpsum balance built up in ELSS funds may be held until we are happy with the returns they are generating, our until our portfolios are next due for a rebalance.
Any lumpsum balances accumulated in ELSS funds may then be shifted either into large cap index funds or debt products based on our individual risk profiles or the asset allocation demands of the goals for which we originally held ELSS funds. This should make it clear that 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. And their relevance would only continue to diminish in the years to come.
While this may apparently disappoint a large number of Indian investors, 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. And the power to choose from a wider universe of products may mean that we can expose ourselves to products which may be a much better fit for our needs. And when this power is used wisely, either independently or with sensible professional help, we would be able facilitate better wealth creation and enjoy tax benefits that are comparable, if not entirely better than those that are offered by ELSS funds.