Posted On Tuesday, Feb 07, 2023
As you may know, there are multiple tax-saving options in India to save taxes under Section 80C of the Income Tax Act, 1961, such as the Public Provident Fund (PPF), National Savings Certificate (NSC), National Pension Scheme (NPS), Tax-Saving Fixed Deposits, Senior Citizen Savings Scheme (SCSS), Post Office Monthly Income Scheme (POMIS), Unit-linked Insurance Plans (ULIPs), endowment plans, Equity-Linked Saving Schemes (ELSS), and many more. But if you are looking for an efficient tax-saving investment option that can help you create wealth with market linked investments while saving your taxes, then ELSS could help you achieve your objectives.
It is one of the most sought-after tax-saving investment instrument due to the several advantages. Some of the key benefits of investing in ELSS are:
As per regulatory guidelines, an ELSS or Equity Linked Savings Scheme is mandated to invest at least 80% of its underlying assets in equity and equity-related instruments. The scheme has a mandatory lock-in period of three years. Every SIP instalment too is subject to this lock-in period. The investment made in ELSS entitles you to a deduction (from Gross Total Income) of up to Rs 1.5 lakh (the aggregate limit) per financial year.
Prudent selection of ELSS holds the potential to earn long term risk adjusted returns.
When calculating returns on ELSS or tax-saving mutual funds, factors like initial investment, additional investment (if any), redemption amount, and redemption dates play a crucial role. Here are different ways to calculate returns on ELSS:
Absolute Returns are simple to calculate and understand. Absolute Returns are total returns that tell you how much gain or loss you have made on your investment. The measure of absolute return is the growth experienced over time when you compare the final value of an investment with the initial investment.
It can be calculated with a simple equation all of us have learned in school:
Absolute Returns = (Final Value – Initial Value) / Initial Value X 100
Let’s take an example of an ELSS investment.
Suppose Ms Shweta invested Rs 1,50,000 in an ELSS or tax-saving mutual fund scheme in April 2019. Now that she has completed the lock-in period, she is calculating her returns so that she can decide whether or not to continue with the scheme. For simplicity of the calculation let us assume the current value of her investment is Rs 2,00,000. So, as per the equation, her Absolute Returns will be:
= (2,00,000 – 1,50,000) / 1,50,000 X 100
The drawback of Absolute Returns is that it does not consider the investment period. While the 33.33% return sounds fine, would it be fine if it was generated over a period of 5 years or 10 years? Absolutely not. That is why your investment decision should not be solely based on the Absolute Returns generated by the scheme.
CAGR or Annualised Return captures year-on-year returns on ELSS or any fund. It provides the annualised returns earned by an investment based on the initial invested amount, the final value of an investment, and the investment period. In simple words, it tells you the mutual fund scheme’s average annual returns or smoothened over a specific period of time.
It can be calculated as under:
CAGR = (Final Value / Initial Value) ^ 1/n – 1
Here, the Final Value is the current value of the investment, Initial Value is the initial investment made, and, n is the investment period in years.
Let’s continue with Shweta’s example. As Absolute Returns cannot give her a clear picture of the scheme’s performance over the past three years, CAGR that shows the annualised ELSS funds returns would help measure the returns better:
= (2,00,000 / 1,50,000)^1/3 – 1
Similarly, you can calculate CAGR for different investment periods. If Shweta had received the same returns over a period of 5 years, the CAGR would be = (2,00,000 / 1,50,000) ^ 1/5 – 1, i.e. 5.92%.
While CAGR represents the annualised returns, it does not mean that the ELSS scheme generated 10.06% returns every year. It could be possible that the underlying value of the investment wasn’t a smooth ride as it is pictured by the CAGR. Let’s see the actual returns earned by the ELSS scheme Shweta has invested in:
Investment Value (in Rs)
Year-on-Year returns (%)
So, the annualised return or CAGR does not necessarily mean the scheme earned or will earn steady returns.
Furthermore, while CAGR could be a good tool to calculate the annualised returns, it cannot be used to calculate the returns when there are multiple cash inflows and/or outflows like SIP and SWP or additional investment or redemption in between. In such a case you need to calculate the Extended Internal Rate of Return (XIRR).
Extended Internal Rate of Return, popularly known as XIRR is a method used to calculate ELSS returns when there are multiple transactions (inflows and outflows) happening at different times.
It is a good Microsoft Excel function that can be used to calculate mutual fund returns if you are investing through SIP, redeeming through SWP, or making multiple investments and redemptions as per your financial situation. The XIRR take care of all these scenarios and help you evaluate the actual returns on your investment, i.e. overall CAGR for all those investments and redemptions taken together.
To calculate the XIRR, all you need to do is to enter the cash inflows/outflows along with the dates of transactions in an Excel sheet. Keep in mind that you are required to enter all your cash outflows i.e. SIP instalments or lump sum investments as negative values, and all your cash inflows, i.e. SWP redemptions and mutual fund withdrawals as positive values. Then, in the last row, enter the current value of the investment along with the date.
XIRR formula to use in Microsoft Excel is:
Note: You can keep the ‘guess’ blank or put any value when you are calculating past returns and put any guess of expected returns when you are calculating potential returns. Suppose instead of a lump sum investment of Rs 1,50,000 in an ELSS mutual fund scheme, Shweta had started a monthly SIP and wanted to calculate the XIRR for the last year. In this case, the XIRR of the scheme would be:
To get the XIRR, you need to type in the formula in the cell as under:
=XIRR(B2:B14,A2:A14)*100 and hit enter.
So, the XIRR of the ELSS SIP that Shweta had invested in for the last financial year comes to 32.39%.
ELSS investment comes under Long Term Capital Gain (LTCG) as the lock-in period for the investment is three years. However, after the lock-in period, you can continue to hold your ELSS investment without any capping.
Long Term Capital Gains are taxed @10% on the amount exceeding Rs 1 lakh during the financial year. So, if your booked LTCG is less than Rs 1 lakh, it will be exempted from the tax.
If we go back to our earlier example, Shweta who earned Rs 50,000 will not be taxed for LTCG as it is less than Rs 1 lakh. If she had invested Rs 3 lakhs and earned 2 lakhs on the investment in a span of five years, she would have been taxed as per the above rule. So, she would have to pay 10% tax on Rs 1 lakh (2 lakh – 1 lakh), i.e. Rs 10,000.
If you have opted for the pay-out of the IDCW (Income Distribution cum Capital Withdrawal) option or dividend option and earn IDCW in a lock-in period, it will be added to your taxable income and taxed as per your income slab. So, if you fall under a 30% tax bracket, you will have to pay 30% tax on IDCW. Hence, ideally, it makes sense to choose the Growth Option over the IDCW option.
Evaluate your ELSS investment returns thoughtfully, whereby you get a clear picture of the returns you made. To simplify your calculation, several financial websites provide ELSS returns calculators, which can help you calculate approx. returns by providing certain information like initial investment amount, date of investment, current investment value, etc. And also consider the tax implications on the ELSS or tax-saving funds returns to understand the post-tax returns clocked.
Get In Touch
Take small steps in financial planning to achieve big dreams! Start your investment journey today!