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An equity-linked saving scheme (ELSS) is an open-ended equity mutual fund that invests a major portion of their corpus into equities and equity-related instruments. These category of mutual fundsqualify for tax deductions and are popularly known as tax saving mutual funds.
At the time of tax-planning, several tax payers weigh upon ELSS owing to the potential for high returns and comparatively lower lock-in period. Tax saving mutual funds or ELSS offer tax exemption benefits under Section 80C of the Indian Income Tax Act, 1961. By investing in ELSS, investors can claim up to a maximum of INR 1.5 lakh as tax deduction benefits.
One of the major reasons why investors consider ELSS is because of their lower lock-in period of three years. Comparatively, a public provident fund (PPF) has a 15-year lock-in period and a tax-saving fixed deposit (FD) has a lock-in period of five years while the national pension scheme (NPS) has a lock-in period till retirement.
After the lock-in period is over, the units are free to be redeemed or switched. ELSS offers options to invest across both growth and dividend options. Among tax saving avenues, these funds have the highest potential of wealth creation in the long term. Investors should carefully analyze the fund track record and after careful consideration invest depending on their financial goals and risk appetite.
Features of ELSS
- Dual benefit: Investing in ELSS provides dual benefits of wealth creation as well as tax benefits: Investors can claim up to INR 1.5 lakh as tax deduction benefits. ELSS have majority investments in equity, and hence have the potential to deliver optimal returns
- Lowest lock-in period: This is the only Section 80C investment with the lower lock-in period of three years
- Mode of investment: Investors can choose via SIP method or invest in lump sum. It is advisable to choose the systematic investment plan (SIP) method as investors can invest in small amounts and additionally avail the benefits of rupee cost averaging
- Minimum investment: The investors can invest as minimum as INR 500 for SIP in ELSS
- Investment horizon: It is essential to be invested for a minimum of three years while opting for ELSS mutual funds. The investors have the option to even remain invested for longer period of time and yield higher returns over a long time investment horizon
- Diversification: ELSS mutual funds invest majority of funds in equity and equity- linked instruments and other securities, thereby diversifying portfolio. The diversification helps prevent huge losses during highly volatile market conditions
- Taxation: After the lock-in period of three years, the long-term capital gains (LTCG) of up to INR 1 lakh a year from ELSS mutual funds are exempt from income tax. Additionally, Long Term Capital Gains above INR 1 lakh is taxed at 10%.
Decoding the lock-in period of ELSS mutual funds
While investing in ELSS or tax saving mutual funds, investors buy some units of mutual funds at NAV and the lock-in period applies to those units purchased. Investors can redeem these units after three years of lock-in time. For instance:
a) If an investor invests INR 1,00,000 in March 2022 in a lump sum mode of investment at NAV of INR 100, then the investor gets 1000 units with a lock-in period of three years. After three years, in March 2025, all these 1000 units would be available for redemption.
b) If the investor invests INR 1,00,000 in ELSS mutual funds through an SIP method for equal instalments of INR 20,000 per month through March 2022 to July 2022, at NAV of INR 100, the investor is subjected to an allotment of 200 units each month, with total 1000 units purchased over a period of five months. Here, the lock-in period of 200 units purchased in March 2022 would be available for redemption in March 2025, and another 200 units in April 2025 and so on.
Who Should Invest In ELSS?
Though ELSS have some of the very good features and have given remarkable returns in the past, they may still not be suitable for each and every one.
- As ELSS invests over 80% of funds in equity and equity-related instruments, these have higher risks due to market volatility. ELSS are not suitable for a person who does not have a higher risk appetite.
- Older individuals might consider other investment instruments which carry lower or no capital risk. As the lock-in period is three years, the markets might not perform well in a short three year time frame and hence investors might have to continue to hold the investments till market recovers.
- Investors should also have a flexible long term time horizon to reap maximum benefits or ensure higher returns. It is advisable to invest for a timeframe of around six to seven years to reap long-term benefits.
- Investors should carefully analyze the fund track record and after careful consideration invest depending on their financial goals and risk appetite. Young investors, who are early into their career and have a long time tenure to stay invested can take the maximum advantage of ELSS mutual funds.
Should You Choose SIP Vs Lump Sum While Investing in ELSS?
Both one-time and SIPs are beneficial for individuals. The choice to invest in ELSS through SIP or lump sum depends on one’s liabilities and financial goals. If investors are looking to save tax at the end of the financial year, then choosing a lump sum method is the most viable option.
However, if an investor is investing at the beginning of the financial year, one can either invest in lump sum or via SIP route. SIP involves regularly investing small amounts of money in a disciplined way and is advisable if one is a first-time investor. Investing via SIP route helps lower the risk as investments are spread over a longer time period.
Additionally, investors can get a better average price for units by investing at different NAVs through the year compared to lump sum investment due to rupee cost averaging.
Factors to Consider While Choosing Tax Saving Mutual Funds
- Performance History
Analyzing past performance helps to determine how the tax saver scheme has performed. This helps investors make an informed investment decision. However, past performance is not an indicator of how a fund will perform in the future.
- Expense Ratio
Expense ratio is the amount of the investment that goes into managing the funds. An investor needs to carefully consider the expense ratio as expense ratio can have a direct impact on the returns generated. The lower the expense ratio, higher would be the returns and vice-versa. In the case of two funds with a similar track record and asset allocation, one can consider a fund with a lower expense ratio.
- Fund size
Funds that have performed better are usually favored by investors and hence have larger AUM compared to other underperforming funds. Investors should take into consideration the size of the fund, which is considered a good indicator while opting a fund. However, this criteria should not be chosen for newly launched ELSS mutual funds.
While choosing the right ELSS scheme, investors should carefully consider the long term performance of the fund and opt for funds that have delivered consistent performance.
Bottom Line
Tax saving benefits, potential for long-term wealth creation and comparatively lower lock-in period makes ELSS mutual funds a great investment choice for investors. Investors should carefully study the ELSS funds before investing. Investors should also analyze their long-term and short-term financial goals, risk appetite and then only invest in ELSS mutual funds, as ELSS mutual funds are high-risk investments.
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Saurav BasuContributor
Saurav heads the wealth management business at Tata Capital. He has more than 20 years of experience in the financial services sector. Prior to joining Tata Capital, he worked with Citibank and Philips India. Saurav is an alumnus of Indian Institute of Management, Lucknow and National Institute of Technology, Suratkal.
Aashika JainEditor
Aashika is the India Editor for Forbes Advisor. Her 15-year business and finance journalism stint has led her to report, write, edit and lead teams covering public investing, private investing and personal investing both in India and overseas. She has previously worked at CNBC-TV18, Thomson Reuters, The Economic Times and Entrepreneur.
