“Bank Fixed Deposits are not going to work for me! I am planning for building up a fund for paying off my daughter’s college fees.” Mr. Iyer was telling me the other day.
“I want to know where I can invest for 5 years so that I would be able to pay off the college fees easily after 5 years?” Mr. Iyer was indeed worried because he is not able to understand how to work this out.
Mr Iyer is a representative example of the common man to whom any of us can relate to. There are so many financial instruments in the market, then how to choose the correct one suited for our financial goal. Let’s see in this case study where Mr Iyer can invest fruitfully for 5 years in ELSS vs PPF Public Provident Fund
Let’s understand what are ELSS (Equity Linked Saving Scheme) and PPF (Public Provident Fund)
ELSS refers to Mutual Funds that invest 80% or more in equity i.e. shares and securities. ELSS is one of the primary tax saving instruments which has a lock-in period of 3 years. Investors can invest in ELSS in a lump sum or through SIP (Systematic Investment Plan). SIP requires that the investor should invest a fixed monthly amount in a selected ELSS fund.
Read more about ELSS Funds – 7 Reasons Why ELSS Has Evolved Into A Popular Tax Saving Alternative
PPF refers to another tax saving instrument which is a rather long term investment term of 15 years. The investors would be required to open a PPF account wherein he is required to invest monthly or annually.
The differences between ELSS and PPF
|Lock-in period||An investor needs to stay put in ELSS for the minimum period of 3 years to get a tax deduction benefit on the investment under section 80C||Lock-in period for PPF is 15 years which is much higher as compared to ELSS.|
Even though partial withdrawal is allowed after 5 years, substantial money will still be blocked till maturity.
|Liquidity||Due to 3 years lock-in period, the investor can easily redeem or sell to quench its liquidity needs||Due to greater lock-in period, PPF can be touted as an illiquid instrument, more suited to long term financial goals like retirement planning etc.|
|Returns and risk ratio||ELSS has a moderate to higher risk and returns ratio since 80% or more of the funds are allocated towards shares and securities in the open market. Returns could be on an average 10-13% p.a. The risk could be in the corresponding % due to market uncertainty||PPF has a lower risk-return ratio since it is a government scheme. Returns could be around 7-8% as dictated by government. Risk is very less since the returns are guaranteed by the government|
|Taxation||Investment in ELSS is covered under section 80C deduction, however, the capital gains are taxable above the limit of Rs.1 lakh||PPF has an EEE structure meaning that investment, returns, as well as maturity proceeds, are exempt from the income tax purview.|
Let’s compare ELSS and PPF for Mr. Iyer
I showed all this data to Mr. Iyer who was again confused, “Anna, it looks like both ELSS and PPF have their pros and cons. How would I know which one is better for me?”
So here is the comparative chart where it is assumed that Mr. Iyer invests Rs. 5000/- per month in ELSS and PPF.
|Year||The amount received annually if Rs.5000 invested in ELSS||The amount received annually if Rs.5000 invested in PPF|
*assuming that ELSS earns a rate of return around 11.5% and PPF earns around 7.1%
Analysis of the case study
- Looking at lucrative returns earned by the ELSS, ELSS definitely makes a good option for a 5-year investment option
- However, while considering the higher rate of return, we also must attach the risk carried by ELSS in the form of unguaranteed returns and loss of principal.
- PPF returns even if secure and easiest way for investing, definitely takes a toll on the liquidity stature of the investor. Since PPF allows only partial withdrawal after 5 years, there is no chance that Mr. Iyer could take out money before that threshold.
- PPF is the most secure form of investment since it is backed by the government. Even if the rate of return does not factor in the inflation cost, there is no default risk or market risk in PPF.
- If we keep on populating the returns for both ELSS and PPF for a longer period, ELSS would bag the surge in returns in the long term considering that markets will be in the progressive mode of operation.
I suggested Mr. Iyer take an independent decision based on the below pointers. Hope it helps you all too to take a big leap.
- If Mr. Iyer wishes to conserve the capital and is wary of the stock market, then he can put his money in PPF. This would give him the guaranteed returns and security of principal invested. However, the con side to this would be
- Comparatively lower returns
- No inflation factoring of returns
- The long term Lock-in period of 15 years resulting in a liquidity crunch
- If Mr. Iyer has a moderate to high-risk appetite, then he can think of putting his money into ELSS funds to secure a higher rate of return. ELSS would be a very liquid asset as well as a high return bracket. However, there are few risks to think of
- Loss of principal due to market risk
- Unguaranteed returns
- Alternatively, Mr Iyer can divide his investment in PPF and ELSS to reap higher returns and square off the losses.
It is that time of the year when the salaried as well as the non-salaried hunt for various tax-saving investment avenues. A smarter approach is the one where tax-saving is taken up early in the year rather than making it a later affair. When one chooses a tax saving investment there are a few factors that need to be considered like safety, returns, lock-in and liquidity. Here are various avenues which provide not only tax benefits but also an opportunity to earn tax-free income. Some of the tax-saving investments under sec 80C are as follows:
Equity Linked Saving Scheme:
Equity-linked savings schemes (ELSS) are equity mutual funds where the investment amount in them qualifies for tax benefit while the lock-in period being the lowest of 3 years. There are two options available to invest in ELSS i.e either the dividend or the growth option. After the lock-in ends, one may continue with the ELSS investments similar to an open-ended mutual fund scheme. it is advised to review its performance against its benchmark. ELSS not only helps you save for a long term goal but also helps you save tax and generate tax-exempt income.
National Pension Scheme:
The NPS provides a three fold benefit to all the investors:
- U/s 80C- Tax exemption upto INR 1.50lac
- U/s 80CCd(1b)- Additional expemtion upto INR 50000
- Upto 10% of the basic salary contribution towards NPS is not taxed.
Even with the popularity of the NPS, at the time of maturity only 40% is tax exempt. Since NPS invests in both bonds and equity, one is entitled to good returns.
Public Provident Fund:
the favorite investment scheme of all time where the principal and the interest earned have a sovereign guarantee and the returns are absolutely tax-free.PPF offers 7.9% percent per annum (subject to change). The minimum investment amount required is INR 500 to keep the account active. After all, the principal and the interest earned have a sovereign guarantee and the returns are tax-free. The PPF is a 15-year scheme, which can be extended indefinitely in a block of 5 years.
National Saving Certificate:
A government initiated scheme which provides ease of transacting along with security. One can invest in NSC via any post office in India. This scheme is designed for mid-income investors who are looking for risk-free investment avenues. The investors who invest in the scheme for the second consecutive year as well can benefit from the deduction on NSC and also the interest earned in previous year as it is compounded annually.
Sukanya Samriddhi Scheme:
Launched under the Beti Bachao Beti Padhao campaign, the SSY is especially designed for the girl child. The scheme is eligible for tax exemption along with the interest that is compounded annually. Currently the scheme gives out a return of 8.1-8.5%% with a minimum investment of as low as INR 250. One can invest in this scheme from the birth of a girl child upto the age of 10 while the scheme remains operative till the age of 21.
Senior Citizen Saving Scheme:
A government backed saving scheme for the senior citizens which aims at providing financial security along with tax saving opportunity. Any individual who is above 60 years is eligible for this scheme, a minimum of one-time deposit of INR1000 is mandatory and one can invest upto 9Lacs(Single holding) INR15lacs(Joint-Holding). The scheme comes with a minimum lock-in of 5 years with quarterly interest payments. One can avail upto 1.5l as deduction while earning a whopping 8.7% return which is ensured. All major public sector banks provide with the SCSS.
PPF is one of the most popular tax saving as well as investment instrument as it comes with EEE tax framework. Additionally, PPF comes with so many features that it is difficult to resist. This article will focus on everything related to PPF.
What is PPF?
PPF refers to Public Provident Fund. This is a unique investment instrument which comes with long term time horizon. It is best suited for long term financial goals like marriage or education of the kids or retirement planning.
Features of PPF
- Tax saving
PPF can be used as tax saving instrument as investment in PPF comes under section 80C for claiming deduction from the taxable income.
Additionally, due to its EEE structure, PPF gives out exempt income and exempt maturity along with tax free deductions (80C deduction for accumulation or investment amount).
- Interest rate
PPF interest rate is directly linked to market interest rates. Recently, Government announced that small savings interest rate will be set quarterly and would be linked to comparable government securities. So, from now onwards PPF interest will be directly impacted by government securities interest rate and it will never under perform this secure benchmark. Currently this interest rate is around 8.1%, which will of course keep on changing to keep in pace with the market interest rate.
- Lock in period
Lock in period for PPF is 15 years, hence it is most suitable for long term financial goals. Even though partial withdrawal is allowed, it is only after completion of 5 years from opening the said PPF account. Further amount can be withdrawn only for certain emergencies like medical emergencies etc. and there is upper cap for the same.
- Compounding effect
Due to the longer lock in period of 15 years, PPF can beat other instruments based on compounding or accumulation effect.
Since, withdrawal (partial) is allowed only after 5 years, interest on corpus invested gets compounded at existing interest rate at least for 5 years and at maximum for 15 years. So, if you invest Rs.100 each year for 15 years today in PPF, you will get around Rs.2963 in 15th year.
- Liquidity factor
PPF being a long-term investment instrument, liquidity crunch may be a biggest hurdle. During the whole tenure, only after 5th year, the PPF investor can withdraw partially.
Even if the investor decides to stay put in the PPF investment, funds invested as well as interest on it will be locked in for 15 years.
Why PPF is to be opted for?
- Tax free returns
Since PPF comes under EEE framework, the interest on PPF investment will be exempt. This interest gets compounded annually and at the time of maturity, you will get enhanced amount which is absolutely tax free i.e. tax free interest + tax free corpus (principal).
- Reasonable return
PPF interest rate is linked to government securities interest rate. This interest rate is set quarterly;however, this ensures that PPF will never disappoint the investor. This benchmark ensures the safety in the sense that it will never dip down that mark.
- Smallest investor can participate
PPF can be opened and kept alive only with a meager investment of Rs.500 which makes it possible for even a smallest investor to take benefit of long term compounding.
- Attractive as compared to conventional saving instruments
Suppose if you invest in Bank Fixed deposit which gives out interest rate of 7.5 – 8%, which are before tax and not factored to inflation effect.
On the contrary to this, PPF returns are after tax returns and can battle with inflation till maturity due to compounding effect.
- Best retirement planning instrument
Being most safe saving instrument, PPF can be effectively used in retirement portfolio. Point to be noted is that, you should invest more and more at much young age, which would benefit you by enhanced compounding effect.
Points to be noted
- You should first identify your long term financial goals and invest in long term investment instruments like PPF. This would enable you to match payout date and maturity date (which will ease your liquidity position).
- PPF investment is capped at upper level for Rs.1,50,000 and hence one cannot invest more than that threshold limit.
- NO permanent closure of PPF account is allowed prematurely. This leads to lack of flexibility.
- PPF rates keep on changing and may even decline if there is rate cut. However, it will never go down its benchmark rate of interest.
- As compared to ELSS or other newer investment options, PPF lags on flexibility and inflation adjusted returns factors. However, it is suitable for risk averse and conventional investor.
- It can be opened at any post office, or any prescribed nationalized or private banks.