How is ELSS different from an SIP?

Introduction

ELSS and SIP are two of the most common terms you encounter when you look into mutual funds. So, it is no surprise that one may very well try to compare the two. However, even though the title of this article might imply that ELSS and SIP are comparable, in reality, you cannot compare these two. 

The simple reason is that Equity-linked Saving Scheme or ELSS, as it is popularly called, is a type of tax-saving mutual fund scheme, whereas a Systematic Investment Plan or SIP is one of the two ways of investing in mutual funds, which also includes ELSS.

So, instead of comparing them, let's look at both the concepts and their features.

What is ELSS?

ELSS is the only category of mutual fund eligible for tax benefits under section 80C of the Income Tax Act, 1961. Investing in an ELSS fund can help you lower your taxable income by upto ₹1.5 lakh per year in the highest tax bracket of 30%. This would, in turn, help you save up to Rs. 46,800 in taxes each year. 

However, this will only be applicable if you opt for the old tax regime. You will not be able to claim such a deduction if you opt for the new tax regime. This scheme gives you the dual benefit of tax saving and wealth creation if you stay invested for the long term.

Key Features of ELSS

• Tax-saving opportunity
• Lowest lock-in period among tax-saving investments
• Potential to beat inflation in the long term
• Opportunity to invest via lump-sum or SIP
• Provides in-built diversification by tapping into stocks of different companies belonging to different market capitalization and sectors.
• Offers a high level of transparency
• No maximum limit of investments

What is an SIP?

Mutual funds, in general, offer you the option to invest either via lump-sum or SIP. Now, lump-sum would be making a one-time investment, preferably a vast sum. However, a Systematic Investment Plan (SIP) is a method of investing regularly with small amounts. 

So, using an SIP, you can make regular payments to a mutual fund scheme like the ELSS.

Key Features of SIP

• Makes investing convenient and affordable
• Offers you an option to set the frequency convenient to you: weekly, monthly, quarterly, semi-annually, or annually. 
• Helps you benefit from rupee cost averaging, wherein your fund manager buys more units when the Net asset value of the scheme (NAV) is low and less when the NAV is high. This means you don’t have to time the market.

Combining the benefits of ELSS and SIP

Now, as you know, you can choose to invest in ELSS via SIP. However, when you choose the SIP route to invest in ELSS, you have to remember that the lock-in period of three years applies to every SIP instalment.

For example, if you pay ₹5000 in October of 2021, the lock-in period for the investment made with that instalment will be October of 2024. If you pay another ₹5000 in November of 2021, the lock-in period for the investment made with that instalment will be November of 2024.

Another thing to remember would be that after the lock-in period when you do sell your units in an ELSS, you will have to pay a long-term capital gain tax.

According to the Income-tax rules, any investment that is held for more than a year is considered a long-term investment. Any gain that you made out of the sale of this investment is a capital gain and is taxable.

For an ELSS, since the units are held for a minimum of 3 years, you are exempted from paying tax on the initial Rs.1 lakh of profit earned but the remaining gains are taxed at 10 percent. 

So say, you have invested ₹10,00,000 in an ELSS via lump-sum and decide to redeem your investment after the lock-in period for ₹12,00,000. 

Your profit will be (12,00,000-10,00,000) = ₹2,00,000. 

The long-term capital gain (LTCG) is ₹2 lakh. However, you are exempt from paying tax on the initial ₹1 lakh gain. 

The remaining LTCG of ₹1 lakh will be taxed at 10%, along with surcharges and cess. 

Thus, the tax on long-term capital gain is ₹10,000 (1,00,000*10/100) plus surcharges.

Now, let's assume you have invested ₹10,80,000 in ELSS by making regular payments of ₹30,000 each month. You still have to pay long-term capital gain tax on the gains you make when you decide to sell these units. 

Let’s assume you sell these units for ₹12,50,000, which after your last instalment has completed the three years lock-in period. 

Your long-term capital gain is ₹1,70,000. 

As explained above, you are exempted from paying tax on ₹1 lakh

But you will need to pay a long term capital gain tax of ₹7,000 (70,000*10/100) plus surcharges.

Conclusion:

Combining ELSS and SIP is a perfect recipe for a successful investment strategy. Investing in ELSS helps you save tax and grow your wealth in the long run, whereas using an SIP to do so helps you average out your cost of investment and tackle market volatility. 

Together, they work towards helping you make the most of your investments.