Investors look for investment opportunities that can help them generate wealth, get regular returns, and/or save taxes. While there are numerous investment schemes available in the market, most of them offer returns that are taxed according to the Income Tax rules. This is where ELSS funds step in. Equity Linked Savings Schemes or ELSS mutual Funds are tax-saving equity mutual funds.
An ELSS fund or an equity-linked savings scheme is the only kind of mutual funds eligible for tax deductions under the provisions of Section 80C of the Income Tax Act, 1961. You can claim a tax rebate of up to Rs 1,50,000 and save up to Rs 46,800 a year in taxes by investing in ELSS mutual funds.
ELSS mutual funds’ asset allocation is mostly (65% of the portfolio) made towards equity and equity-linked securities such as listed shares. They may have some exposure to fixed-income securities as well. These funds come with a lock-in period of just three years, the shortest among all Section 80C investments.
What are the features of ELSS funds?
Some important features of ELSS funds are as follows:
- A minimum of 80% of the total investible corpus is invested in equity and equity-related instruments
- The fund invests in equity in a diversified manner – across different market capitalizations, themes, and sectors.
- There is no maximum tenure of investment. However, there is a lock-in period of three years.
- Tax exemption on the invested amount under Section 80C of the Income Tax Act.
- Income is treated as LTCG and taxed according to the prevalent tax rules.
How Does ELSS Funds Work?
ELSS funds are equity funds with a diverse portfolio. These funds primarily invest in publicly traded firms’ stocks. The stocks are drawn from a variety of market capitalizations (large, mid, and small companies) and industries. These funds seek to optimize long-term wealth appreciation. The fund management selects stocks after doing extensive market research to achieve the best risk-adjusted portfolio returns.
Investments in an ELSS fund are tax deductible under Section 80C of the Income Tax Act of 1961. While there is no upper limit on the amount that can be invested, the IT Act allows for a tax deduction of up to Rs. 1.5 lakh. Investing this amount in an ELSS can result in tax savings of up to 46,800 per year.
What are the factors to consider before investing in ELSS
- Investment horizon: You need to have an investment horizon of longer than five years to consider investing in ELSS funds. The equity exposure of ELSS funds requires you to have a longer investment horizon in order to mitigate market volatility.
- Returns: You need to understand that ELSS funds do not provide guaranteed returns as they are dependent entirely on the performance of the underlying securities. However, having an investment horizon of longer than 5 years can provide higher returns than any other tax-saving investment option.
- Lock-in period: ELSS mutual funds come with a lock-in period of three years. Your investments are mandatorily locked-in for three years from the date of investment, and you cannot redeem your holdings until the completion of this period.
What should be the mode – SIP or Lumpsum
Investing via an SIP is advisable if you are not willing to take higher risk. When you invest through an SIP, you get the opportunity of investing in a fund across business cycles. This helps you get the benefit of purchasing the fund units across market cycles. When the markets are down, you buy more units while you purchase fewer units when the markets are bullish. Therefore, over time, your price of purchase of fund units gets averaged out and turns out to be on the lower side. You will benefit from this when the markets rise as you can realise higher capital gains on redemption. This benefit is not available if you invest a lump sum.
Investing a lump sum is not advisable unless the markets are gripped by a bearish trend, and you are willing to take higher risk levels and have a longer investment horizon. You miss out on the opportunity to purchase fund units across business cycles, which requires you to stay invested for longer than 5-7 years to realise good gain
Taxation Rules of ELSS Funds
Since ELSS funds are locked up for three years, there is no way to realize short-term profit gains. As a result, you can only realize long-term capital gains. These gains are tax-free up to Rs 1 lakh per year, and any earnings beyond this amount are subject to a 10% long-term capital gains tax.
As mentioned above, Section 80C of the Income Tax Act offers tax deduction benefits on the principal invested by you in an ELSS scheme. This is a cumulative deduction benefit, meaning you can avail of a tax deduction of up to Rs. 1.5 lakh under the above-mentioned section for investments made in all instruments specified, like ELSS, NSC, PPF, etc.
Further, these schemes have a mandatory lock-in period of 3 years. Therefore, on redeeming the units, you receive long-term capital gains or LTCG. These gains are not taxable up to Rs. 1 lakh in one financial year. Any LTCG above this limit is taxed at 10% of the gains exceeding Rs. 1 lakh without indexation.
FAQs
Why should you invest in ELSS Tax Saving Mutual Funds?
ELSS Tax Saving Funds offer a wide range of benefits including:
- Diversification – Most ELSS funds invest across a diverse group of companies ranging from small-cap to large-cap and across various sectors. This allows you to add the element of diversification to your investment portfolio.
- Low minimum amount – Most ELSS schemes allow investors to start investing with as low as Rs.500. This ensures that you start investing without having to accumulate a reasonable investible corpus.
- SIPs – While you can invest a lump sum amount in an ELSS scheme, most investors prefer the SIP method as it allows them to invest in small amounts and avail tax benefits along with an opportunity to create wealth.
Additionally, you can invest as much as you want but can avail tax benefits as limited by Section 80C of the Income Tax Act. Also, you can choose to stay invested after the stipulated lock-in period of 3 years for as long as you want.
What are the tax benefits offered by ELSS funds?
ELSS mutual funds provide tax deductions of up to Rs 1,50,000 a year under the provisions of Section 80C of the Income Tax Act, 1961. This helps you save up to Rs 46,800 a year in taxes. However, note that your investments are locked-in for three years from the date of investment.