Income tax return: ELSS vs PPF as tax-saving option as equity scores in the long run

The recent increase in the small savings schemes interest rates, accompanied with meltdown in the equity market, has created a perception that Public Provident Fund (PPF) is a better tax saving product than Equity Linked Savings Scheme (ELSS).

Adding to this perception is the 10% tax on equity shares and equity oriented mutual funds, introduced last year, which also applies to ELSS. But is PPF really better than ELSS?

Interest v/s inflation

The average investor does not understand the interplay between interest and inflation. Instead of focusing on the nominal rate of interest on PPF, investors should focus on the real interest rate that the PPF account offers. A real interest rate is effectively the inflation adjusted rate of interest one earns on his investment. It is the coupon rate of interest offered on an instrument, as reduced by the current inflation rate.

As the PPF interest rate goes up, banks have been crowded out and they will not be able to attract deposits at the currently offered rates of interest. Therefore they will be forced to raise interest rates on fixed deposits. The increased rate of interest on PPF is applicable only for the next quarter. However, if the yield on government securities keeps going up, the PPF interest may still go up in immediate future. In case the interest rate curve reverses again, which is bound to happen sooner or later, the interest on PPF will come down again.

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PPF or ELSS or both?

To reduce the risk and to optimise returns on investments in the long run, investors should adhere to proper asset allocation and ensure that it remains in the same ratio by carrying out re-balancing of assets  periodically. The principle of asset allocation should equally be followed while choosing investment products for tax savings as well. You should allocate all your investible funds, for claiming tax benefits, between ELSS and PPF rationally, unless you are salaried where contribution to employee provident fund (EPF) is proxy of PPF. Even after imposition of 10% tax on equity funds under section 112A and the recent volatility in the equity market, investments in ELSS still remain more attractive, provided one remains invested in ELSS for a longer period. Being an equity product, it is risky for the short term. 

Let us understand this with an example. Two investors invest Rs 1,50,000 every year, for 15 years. The conservative investor invests in PPF and another invests in ELSS. Both avail tax benefits under Section 80 C. I have assumed that the current interest rate @ 8% will remain fixed for the next 15 years on PPF. For ELSS I have assumed 12% annualised returns for the next 15 years. At the end of 15 years, the conservative investor will accumulate Rs 43,98,642 in his PPF account, while the other investor will accumulate Rs 62,62,992 in ELSS. In the 15-year period, the principal investment for both investors will be Rs 22,50,000. Even after deducting tax liability of Rs 4,01,300 @ 10% from the profits of Rs 40,12,992, net maturity value of ELSS will be Rs 58,61,693, which is 33% higher than the one accumulated by the investor who had invested in PPF. The overall tax liability can be reduced by tax planning.

Those who are starting their careers can take the higher risk associated with equity investing and invest in ELSS instead of PPF. However, for retired persons who do not have much risk-taking ability, PPF is preferable than ELSS. Middle-aged taxpayers can make rational allocation between these two instruments based on factors like proximity to the goal/s for which the saving is to be made.

The writer is a tax and investment expert