Most of the tax saving instruments under Section 80C are saving-oriented instruments with returns after adjusting for inflation either in the negative or slightly positive. The exceptions to this are Ulips (Life and Pension Funds) and the ELSS Mutual Funds. The advantage with ELSS compared to the Ulips is the frequency (mostly a single investment or a monthly investment for a year) and term for investment, for getting good returns.

Does ELSS diversify?

An ELSS (Equity Linked Savings Scheme) is a mutual fund that has to invest a minimum of 80% in Equity Shares.

The balance 20% can be in debt, money market instruments, cash or even more equity. There is a 3 year lock-in period for the ELSS mutual funds. Post the 36 months, the funds remain invested and work like any other open-ended mutual fund.

Why an ELSS?

It has been an established fact that in the long run equity gives a much higher inflation adjusted returns when compared to any other investment except for maybe real estate.

ELSS is part of the Section 80C instruments which are cumulatively eligible for a deduction from income up to Rs1 Lakh. The return (maturity and the dividend [(if opted for]) from the ELSS is also tax free under the present EEE (Exempt Exempt Exempt) regime. However, in the the DTC regime, tax benefits are likely to be phased out but could come up for reconsideration before DTC is implemented in 2012.

The 3 year lock-in period makes sure one stays invested. The above logic is proved in the higher returns achieved by the ELSS funds when compared to the market returns. Wealth creation because of this is much better than most of the other mutual funds. Only some sector-based mutual funds have given better returns than the ELSS fund in the past 5 years.

What is the current state of ELSS?

Until now, Equity Linked Service Scheme (ELSS) has been one of the first-choice mutual funds for investors. Studies reveal that Rs 23,700 crores worth of ELSS schemes have been invested in May 2010 as compared to Rs 11,800 crores in May 2007. Between 60-120 lakh people regard ELSS as a tax-saving investment.

Impact of DTC 2011 on ELSS

But all this interest in ELSS is set to change very soon with the advent of the 2011-2012 Direct Tax Code (DTC). Starting April 1, 2012, no new ELSS Mutual Funds will be exempted from taxes taking away one of the biggest USPs of ELSS. This is likely to hit the investors as well as the Mutual Funds industry hard.

Despite the fact that tax benefits for ELSS funds already in existence will continue, there has been a rush among investors to exit these schemes. Another reason people were attracted to ELSS Mutual Funds was the fact that it was the only investment option that allowed interim cash flow during lock-in periods under the 1961 Income Tax Act.

How to best reap ELSS benefits?

The DTC is just a draft Bill and is yet to be passed as a law. So until it becomes an act, investors should wait and not act in haste.

Types of ELSS options

There are two types of ELSS plans, growth option and dividend option:

Growth option: In this option, the investor does not get regular income during the duration of the investment. It is only when the tenure is complete or when the investment is prematurely cancelled that he receives the interest generated.

Dividend option: This is the exact opposite of the growth option and the investor will have a steady amount flowing every month through the duration of the investment. But this is a risk as the income will be unpredictable and erratic. The main disadvantage of this type of investment is that at the end of the 3 years the final value of the investment will not be much.

Dividend reinvestment option: In this option investor can invest the dividends generated from the ELSS fund. However, according to Section 80 C, the reinvested dividends are not liable for tax deductions.