Indian tax laws offer savers an exhaustive range of tax-saving instruments like the Public Provident Fund (PPF), tax-saving fixed deposits, National Savings Certificate (NSC), Equity-linked Saving Scheme (ELSS), and others. And yet, it is extremely commonplace for people to make suboptimal decisions with their tax-saving investments. Why does this happen?
One of the biggest factors responsible for this is the widespread tendency to see tax-saving goals and investment goals as at odds with each other, more or less. People are simply not thinking about tax-saving instruments the same way they think about other investments. That is to say, they do not prioritise the returns on these investments in the same way.
Further, the typical investor makes this decision in late March under the duress of the fast-approaching deadline, or under pressure from a salesperson who drives home the fact that time is running out. The pressure may intensify if the salesperson is a relative or a friend. And the outcome is that a less-than-ideal decision is made. On realising it later, they comfort themselves saying, "at least we got tax benefits."
This approach proves expensive in the long run. Confusion over what to look for in a tax-saving instrument prevents clear-headed thinking about what exactly one is getting out of an investment and whether the quantum of disadvantages are actually worth the quantum of tax benefits obtained.
Investors should work on eliminating the two sources of poor decision-making: time constraints and not thinking through these investments. Eliminating time pressure is simple. Just plan these investments as early in the financial year as possible. Then once you start investing, keep at it through the year till you reach your limit.
As far as the second problem is concerned, for most people, the investment that makes the most sense is an ELSS. Salary-earners generally have some of the permitted amount going into fixed income through PF deductions. To balance that, equity is advisable. ELSS is unique in being the only viable tax-saving investment within the Rs 1.5 lakh limit that brings the benefits of equity returns. Sure, there are two other options that give equity-linked returns - Unit-linked Insurance Plans (ULIPs) and the National Pension System (NPS). However, ULIPs have a longer lock-in period of 5 years, coupled with high costs and poor transparency. The NPS is a retirement solution rather than a savings one. It has only partial exposure to equity and a very long lock-in period that effectively extends till retirement age. There is no way a three year lock-in product like the ELSS can be compared to the NPS.
For many beginner investors, ELSS funds make an excellent gateway product, where they get their first taste of equity investing and of mutual funds. They end up investing in these funds because the tax-saving attracts them and it has the shortest lock-in, and this experience encourages them to invest in equity mutual funds over and above their tax-saving needs. Once you get used to long-term equity returns, you look to try other types of equity investments as well.
Equity investments carry higher risk over the short term. However, for investment periods of five years or more, the risk is considerably lower. When you take inflation into account, bank FDs and similar deposits turn out to be sub-optimal because of inflation. Like all equity investments, the best way of investing in an ELSS is through monthly Systematic Investment Plans (SIPs) through the year. SIPs have two advantages here: first, they protect your investments in a market downturn, and second, you avoid making a hasty lump-sum investment in March. At the beginning of every financial year, estimate the amount you have left over from the Rs 1.5 lakh limit after statutory deductions; divide this by 12 and start an SIP. Simple.
You can find a list of top-rated ELSS funds here.