Mutual Funds for Tax Saving – Why you must avoid?

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Many of us invest in Mutual Funds for tax saving purposes also. These are called ELSS Funds or Equity Linked Savings Schemes. However, in this post, I am sharing with you the reasons why you must stay away from such products.

Mutual Funds for Tax Saving

As you may be aware, ELSS funds are eligible for deduction under Sec.80C for up to Rs.1,50,000. Also, there is a lock-in of 3 years for ELSS Mutual Funds. If you opted for SIP, then each monthly SIP has to complete 3 years to be eligible for withdrawal.

Why tax savers love ELSS Mutual Funds?

# The lowest lock-in among all other options:-

If compare with other tax saving instruments available in Sec.80C, ELSS funds have a lock-in of 3 years. However, others have a minimum of 5 years. This is the primary reason for selecting ELSS Mutual Funds.

# Last minute tax saving

One more reason for running behind these ELSS is the unplanned last-minute tax-saving rush. Hence, without worrying about the risk factors involved, we jump into investing.

# PAST performance

Majority of these investors look back past returns and if the performance is fantastic, then jump into the well of ELSS.

Mutual Funds for Tax Saving – Why you must avoid?

Let us now come to the main topic of this post. As per the definition of SEBI, ELSS Funds means “Minimum investment in equity & equity related instruments –80% of total assets (in accordance with Equity Linked Saving Scheme, 2005 notified by Ministry of Finance”.

Let us now discuss the issues which I am trying to say that why Mutual Funds for Tax Saving should not be your priority to invest in ELSS Funds.

# Introduction of new Tax Regime

With the introduction of the new tax regime, I don’t think there is any logic in considering the Mutual Funds for Tax Savings. Because if you adopted this new tax regime, then you are not allowed to claim the deduction under Sec.80C (Refer the complete post at “New Tax Regime – Complete list of exemptions and deductions not allowed“.

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# Full FREEDOM to Fund Manager

If you notice the definition of ELSS Mutual Funds, you have noticed that SEBI just mentioned that equity exposure should be a minimum of 80%. However, it is silent on what type of market cap a fund should invest. Hence, it gives the freedom for the fund manager to choose a large-cap, mid-cap, or small-cap as per his choice. This poses a huge risk. At first, if you are not in a position to take the undue risk of small-cap, you are forced to take this just because your fund manager found an opportunity in small-cap. It is a kind of BLIND risk-taking ability at your level. How many times these fund managers calls are correct only God knows.

Take for example the holdings of the Top 5 ELSS Muutal Funds (based on AUM).

  • Axis Long Term Equity Fund:-73% in Large, 22% in Mid, and 3% in Small Cap.
  • Birla Sunlife Tax Relief Fund:-46% in Large, 46% in Mid, and 8% in Small Cap.
  • Nippon India Tax Saver Fund:-72% in Large, 16% in Mid, and 12% in Small Cap.
  • SBI Long Term Equity Fund:-70% in Large, 20% in Mid, and 10% in Small Cap.
  • HDFC Tax Saver:-84% in Large 12% in Mid and 3% in Small Cap.

This position is as of today and as I told you they may change their holdings as they wish for rather than as per your wish. Hence, unknowingly you are forced to take the undue risk in the kind of stocks which are in mid or small-cap.

The above facts are about the equity part. As the definition of ELSS is clear that minimum they have to hold 80% in equity, the remaining 20% is sometimes may turn to be risky. However, in the majority of the cases, the fund managers hold this 20% in cash or money market instruments to handle redemptions. But there is no such mandatory that they have to hold in highly liquid assets.

# Equity is for Long Term

It is strange to know how the Government formulates the rules. Debt instruments that are available for tax benefits under Sec.80C are available with a minimum of 5 years of lock-in. However, ELSS which is an equity product must be meant for the long term is available with 3 years lock-in.

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But it does not mean you too follow this BLIND illogical Government rule and risk your investment. Use equity only for your long term goal and that also with proper asset allocation between debt and equity but not completely into equity.

# Filling Rs.1,50,000 under Sec.80C is EASY

I am not sure why many do the hasty decisions while filling this Sec.80C limit. You have many options available like EPF, VPF, PPF, SSY, Life Insurance (Term Life Insurance), or home loan principal. Using these features, you can easily fill the Sec.80C benefit.

But we by nature love the returns more than the typical debt products. Hence, we tend to use ELSS funds than the other options available under Sec.80C.

# Adopt the GOAL based investing

If you adopt the goal-based investing, then you can use EPF and VPF for your retirement goal (as a debt part major portion).

The same way you can use PPF as a debt part of your goals which are more than 15 years away and SSY as a debt part of your daughter’s educational and marriage goal.

But do remember that these debt products come with certain lock-in. Hence, rather than investing all 100% of your debt part, better to use them as a major part of your debt portfolio (around 75% to 80% ) and rest in Liquid Funds.

If you do such goal based investing, then filling the Sec.80C gap is too easy.

# Don’t be in a trap of advisers or AMCs who preach ELSS funds have an edge due to lock-in

Many middlemen and AMCs try to highlight the feature of lock-in that as there is no liquidity risk in ELSS funds, fund managers can manage the funds in a better way. Hence, the probability of generating a superior return is high.

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However, this is a complete MYTH. Lock in itself will not create the GREAT portfolio and also it will not remove the risk completely. It is the fund managers’ risk managing task that is important. Mere 3 years lock is not an add on for the fund to perform better on its own.

# ELSS Funds are not only LOCK IN for you but for your NOMINEEE too!

We all know that for the investors of ELSS, there is a lock-in of 3 years. However, the investors die, then the nominee is not allowed to withdraw the money until the one-year completion of the units (from the date of investment).

Hence, for investors, there is a 3 years lock-in and if he dies, then for nominees it is a year lock-in. I think many investors are unaware.

Conclusion:-Considering all these aspects, I am strongly suggesting stay away from Mutual Funds for Tax Saving purposes. Use other options which are easy to handle and meet your goals rather than being in the trap of advisers or mutual fund companies.

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Basu Nivesh

Basu Nivesh

Basav is a SEBI Registered Investment Adviser (SEBI RIA) practicing the Fee-Only Financial Planning Service. He is a CFP (Certified Financial Planner) and blogger at Basu Nivesh. He services around 300+ satisfied clients.
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