Equity-Linked Saving Scheme (ELSS) is a popular instrument to reduce your tax liability. This financial instrument allows you to claim tax deductions of up to INR 1.5 lakh per year under Section 80C of the Income Tax Act, 1961. A common question you may ask your financial advisor is if you may recycle your ELSS investment after the mandatory three-year lock-in period. In simple terms, it means you exit your ELSS investment and reinvest the same after three years to claim tax deductions during that financial year. This strategy is often used because you may believe that you will be able to reduce your tax liability without requiring to invest any additional amount.
Impact of savings and investments
Recycling your ELSS fund investments is not always the best strategy. ELSS Funds have a lock-in period of three years (Lowest lock-in period as compared to other tax saving instruments). At the end of this period, you may redeem your units. Therefore, you may believe that you may save taxes without making any fresh investment through recycling your older investments.
Compared to other tax-saving investments like Public Provident Fund (PPF), National Pension System (NPS), and fixed deposits (FDs), ELSS has the shortest lock-in period. Therefore, recycling your investments in these funds may be tempting.
How does recycling work?
You invest in ELSS funds for three consecutive years to avail of the Section 80C tax deductions. At the end of three years, the first year investment becomes eligible for redemption. You sell this and reinvest the money in the fourth year to claim the tax benefits. This is how ELSS fund recycling occurs. The biggest temptation is that you are able to enjoy the Section 80C benefits without investing any additional money.
Drawbacks of recycling ELSS investment
While recycling these types of funds may be tempting, it is not always the best strategy. Here are two drawbacks of this strategy:
- Invest longer or miss higher returns.
ELSS plans are diversified equity mutual funds. This means a majority of the fund corpus is invested in equities and related instruments. Equities deliver superior returns when you remain invested for a longer period. The funds may not deliver expected profits (or may even be making a loss) at the end of the three-year lock-in period. Therefore, if you exit your investment at the end of the lock-in period, you may miss the opportunity of earning higher returns in the long term. Most experts recommend that you stay invested in the tax-saver funds even after the lock-in period if these continue to perform well.
- Impact on wealth creation
If you are a salaried person, recycling may adversely affect your financial well-being. Salaried individuals must follow a disciplined investment approach with regular savings to build wealth over the long term. If you recycle your tax-saver funds after the lock-in period, you may not save and overspend your income. Over the years, this will negatively affect your financial health and prevent you from building wealth to meet different goals.
Use ELSS for wealth creation
It is possible that you may include multiple fixed-income securities such as FDs, PPF, and government bonds in your investment portfolio. Including ELSS in your portfolio helps to balance your fixed-income titled portfolio. In addition to diversification, investing in ELSS offers the opportunity to create wealth over the long term. Therefore, you must use these funds as a growth-oriented financial instrument that also offers tax benefits.
It is crucial that you avoid using the recycling strategy for your ELSS investments. It must be sparingly used only during those years when you are facing a liquidity crisis. If you had certain unexpected expenses during the year and find yourself with no money for additional investment, you may consider recycling your ELSS units.
There are a large number of ELSS plans offered by various fund houses. Choosing the right product that matches your investment philosophy and risk profile is confusing and often cumbersome. Furthermore, you may not have the technical expertise to conduct an analysis.
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