How ELSS mutual funds are best for tax savings and retirement planning

Investors can claim up to Rs 1.5 Lakhs of deductions from the taxable income by investing in eligible schemes under Section 80C of Income Tax Act. Apart from tax saving benefits, 80C schemes also serve the long term financial planning needs of the tax payers. If you look at different 80C schemes, you will see that, many of the 80C investment schemes have traditionally been associated with retirement planning. Employee provident fund, Voluntary provident fund, Public provident fund, life insurance policies (both traditional and unit linked), National Pension Scheme(NPS) etc. are all targeted at meeting the retirement planning needs of the tax payers.

Though retirement planning is the most critical financial needs of all citizens, unfortunately in India, retirement planning is not given its due importance. Many people rely mostly on their provident fund (EPF) corpus for retirement savings. In addition to provident fund, investment in public provident fund (PPF) and life insurance policy maturity corpus are seen as supplementary sources of retirement savings. The irony is that, even though, a large number of Indians rely on EPF, PPF and life insurance policies for retirement savings, they do not make these investments with the view of retirement planning. EPF contribution is mandatory for most employees – employers deduct the EPF contribution from the monthly salary of the employees. PPF and life insurance are primarily seen as tax saving investments. Without a financial plan for retirement, many people do not even realize, if they have saved sufficient retirement corpus, until they are close to retirement.

Challenge of retirement planning

There is a retirement planning thumb rule known as 30 – 30 rule. According to this rule, we work for around 30 years, in which we save and invest, so that we can accumulate sufficient corpus, which will last 30 years of retired life. Some families are good savers, but most of us spend much more than we save. If our savings is only a portion of our expenses, then by simple arithmetic, 30 years of savings will not be enough to last 30 years of retired life in an inflationary environment, unless our savings earns substantial returns.

Let us illustrate this problem with numbers, so that you can get clearer sense of the scale of challenge we face in retirement planning. Let us assume you are 30 years old. You will retire at 60. Your current income is Rs 10 Lakhs per year. Let us assume that, your basic salary is 50% of your gross salary. You contribute 12% of your basic salary to Employees Provident Fund (EPF). Your employer makes a matching contribution. In addition, let us assume you will save another 10% of your gross income for retirement planning through PPF and life insurance. Let us further assume that you get a salary increment of 10% every year. The chart below shows how much you will save till your retirement.

If you get 8% return on your savings, then you will accumulate a corpus of around Rs 8 Crores by the time you retire at the age of 60. To put the return of investment in perspective of current interest rates, the current EPF rate is 8.55% and is likely to go down in the future. The current PPF interest rate is 7.8%, while the internal rate of return in traditional life insurance policies is usually around 5 – 6%. The point here is that, the 8% return on savings assumption is not just reasonable, it may even be slightly optimistic if inflation and interest rates come down in the future.

Impact of inflation and lifestyle

Nevertheless, let us assume, you get 8% returns on your retirement savings and accumulate a corpus of Rs 8 Crores – such an amount may sound very impressive to most investors in the Rs 10 lakh income range. What they may be ignoring is the impact of inflation and lifestyle – while your expenses will be substantially higher than what it is today due to the compounding impact of inflation, it is likely to be even much higher due to lifestyle. As our income grows, our lifestyle changes and expense growth related to our lifestyle are usually directly proportional to income.

One of the key challenges of retirement planning is the ability to maintain the lifestyle you had before retirement. Lifestyle is very sticky and extremely difficult to change. Going back to our example, your retirement corpus of Rs 8 Crores, earning a return of 8% post retirement, can support your lifestyle for only about 10 years, that too without factoring in inflation. If you factor in a 5% inflation rate, then your retirement corpus of Rs 8 Crores will last you for only about 7 – 8 years. You still have 20 to 25 years of retired life remaining. This situation implies that, you lose your financial independence at about one third stage of your retired life and you will have to be dependent on your children or other relatives for the rest of your life. In the changing social milieu of our country, this is a highly undesirable situation.

Did you know you can plan your retirement using one of our calculators

Is there a solution?

A simplistic solution is that, you can save more towards retirement. One way in which we can save more, is by earning more, but earning more is usually not within our control – it depends on a variety of factors most of which are outside of our control. The other is to save more and spend less, but it is easier said than done. Inflation in essential commodities, home loan EMIs, children’s education and taxes consume a big chunk of our incomes and leave less for savings.

Higher return on investment

Then what is the solution? The solution lies in getting better returns on your retirement planning investment. If instead of 8% returns you get 15% returns, your retirement corpus will last for around 20 years instead of 7 – 8 years. Is it possible to get 15% return on your investment? Yes, but for that you have to take risk. Without taking risk, it is not possible to earn more than the risk free rate in the economy. The 10 year Government of India bond yield is often taken as the long term risk free rate. The 10 year Government bond yield has on average, over a period of time, ranged between in 7 to 8%. This is about the maximum you can if you are not prepared to take risk. As discussed earlier, the EPF and small savings (e.g. PPF) interest rates are between 7.5 to 8.5% currently and likely to come down in the future.

Equity as an asset class, has historically given higher returns in the long term than all other asset classes. Equity mutual funds, like ELSS mutual funds or equity linked savings schemes (ELSS) have given excellent historical returns over the long term. SIPs in top performing ELSS mutual funds have given around 15 to 20% or more compounded annual returns in the last 15 to 20 years. You should note that mutual fund investments, including ELSS mutual funds are subject to market risks.

See how the top ELSS mutual funds have performed in the last 5 years

Let us now briefly discuss about ELSS mutual funds.

ELSS Mutual Funds or Equity Linked Savings Scheme (ELSS)

ELSS mutual funds are equity scheme that qualifies for tax savings under Section 80C up to a limit of Rs. 150,000. An ELSS mutual fund is essentially a diversified equity scheme with a lock in period of 3 years from the date of the investment. Capital gains of up to Rs 1 Lakh in ELSS mutual funds are tax exempt; capital gains in excess of Rs 1 Lakh in ELSS mutual funds will be taxed at 10%. Dividends paid by ELSS mutual funds are tax free in the hands of the investors, but the asset management company (AMC) will have to pay 10% Dividend Distribution Tax (DDT) before paying dividends to investors. Compared to other retirement planning investments under Section 80C ELSS mutual funds offer higher flexibility through superior liquidity – non ELSS 80C options have a minimum lock in period of 5 years.

Did you know what are the tax benefits of investing in mutual funds versus other investment options

You can invest in ELSS mutual funds either through lump sum or systematic investment plan (SIP). Investment in lump sum is recommended, if you are able to make the entire investment at the beginning or early months of the financial year, so that your investment has enough time to grow during the year. However, if you do not have enough lump sum funds at the beginning of the financial year, then it is more prudent to invest through SIP because it can take advantage of the market volatility through rupee cost averaging and also benefit through the power of compounding by investing regularly over a long period of time. However, when investing in ELSS mutual funds through SIPs, you should note that each SIP instalment will be locked in for 3 years from their respective investment dates.

To know more about ELSS mutual funds do read this – What are tax saving mutual funds

Why is ELSS mutual funds the best tax saving investment to create a retirement corpus over a long investment horizon?

Let us compare, how much retirement corpus you could have accumulated by investing Rs 5,000 through SIP in a top performing ELSS (tax saver fund) versus making Rs 5,000 monthly deposit in your PPF account over the last 20 years. For our analysis, we have chosen a top performing ELSS mutual fund or tax saver fund, with sufficiently long (20 years plus) history – Aditya Birla Sun Life Tax Relief 96 Fund. Let us assume your investment start date in both ELSS and PPF was April 23^rd, 1998. Let us see the results as of end of day, April 23^rd 2018.

You can see the difference in wealth creation. While PPF corpus was around Rs 32 Lakhs, the ELSS mutual fund corpus was more than Rs 1.67 Crores – wealth creation in ELSS mutual fund was more than 5 times of PPF. Look at the difference in returns – while PPF yielded 8.8%, the ELSS mutual funds gave returns in excess of 20% on an annualized basis.

Conclusion

The challenge of retirement planning is serious. Unless we devote sufficient attention and efforts to retirement planning from a young age, we might be faced with a big shortfall when we are nearing our retirement years. ELSS mutual funds is a wonderful tax savings investment option, that can help you plan for retirement planning and at the same time, save a considerable amount of money in taxes if you plan well. As financial advisors, we can help you meet both your retirement and tax planning goals. You can contact us at https://swarajwealth.com/contact

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