ELSS Mutual Funds – Know How You Can Save Your Tax
9 November 2021
Also known as tax-saving mutual funds, ELSS mutual funds, full form Equity-linked Saving Schemes, are open-ended and equity-oriented mutual funds. These funds have the potential to generate higher returns and are also an effective tax-saving instrument.
ELSS funds have the least statutory lock-in period among other tax-saving options, such as PPF and FD.
Let’s understand ELSS mutual funds in detail.
What is ELSS Mutual Fund?
ELSS or Equity Linked Saving Scheme is a type of mutual fund that invests a major portion of its corpus – 80% to be precise – in equity. The remaining 20% is invested in debt instruments.
You can claim tax benefits of up to Rs.1.5 lakh for ELSS investments. These funds come with a lock-in period of 3 years, meaning you can only redeem your investments after three years. The lock-in period is the lowest among all other tax-saving instruments.
Point to note – if you have an ELSS SIP, each instalment would come with a lock-in period of 3 years and would have a different maturity date.
How ELSS Mutual Funds Work?
Equity Linked Savings Schemes or ELSS are classified as diversified equity funds. Fund managers of these funds invest mostly in a wide variety of stocks of listed companies.
The investments are made in specific proportions based on the objective of the fund. The fund manager selects stocks from across market capitalisation, including large cap, mid cap and small cap and other relevant industry sectors
ELSS mutual fund schemes aim to generate optimum returns over the long run. Currently, as per SEBI guidelines, fund managers are allowed to invest 80% of the corpus in equities and 20% in debt instruments.
Who Should Invest in ELSS mutual funds?
ELSS mutual funds are suitable for investors who are looking to invest in equity and save tax under Section 80C of the Income Tax Act. Since these mutual fund schemes primarily invest in stocks, they carry high financial risk. That said, these funds have the potential to generate higher returns in comparison to other tax-saving schemes owing to the equity exposure.
Hence, for individuals, it is key to assess their risk profile before allocating funds to any of the best ELSS funds in India.
Advantages of Investing in ELSS tax saving mutual funds
Here are a few benefits of investing in Equity Linked Saving Scheme:
1. Portfolio Diversification
The best ELSS tax saving mutual funds invest in a range of stocks with different market capitalisation across various sectors to generate higher returns. This diversification reduces portfolio risk.
2. Tax Benefits
Several mutual funds invest in equity and equity-related investment instruments. However, except for ELSS schemes, none offer tax-saving benefits under Section 80C of the Income Tax Act, 1961. These funds present you with the opportunity to save up to Rs.1.5 lakh from your taxable income.
3. Investment Flexibility
ELSS schemes come with a minimum investment value of Rs.500. Moreover, individuals have multiple investment routes to choose from, including SIP (Systematic Investment Plan), SWP (Systematic Withdrawal Plan), and lump sum. Thus, you can choose whichever option is best suited for you.
Returns earned from investing in such mutual funds are taxable upon redemption of the units as per the existing tax norms in India. Taxation rules on these returns are:
STCG or short term capital gains are returns on investments held for 36 months or less. This does not apply in the case of tax saving mutual funds, as the mandatory lock-in period for all ELSS mutual funds is at least 3 years.
If investors sell their units in an ELSS fund after 3 years, the realised returns are referred to as long-term capital gains (LTCG). According to existing laws, such gains of up to Rs.1 lakh are exempted from taxes. Returns exceeding Rs.1 lakh are taxed at 10%.
How to Identify the Best ELSS Funds?
If you wish to identify the best ELSS mutual funds, you need to check the following parameters:
Market cap of stocks in the portfolio
If an Equity Linked Savings Scheme has a high concentration in large-cap stocks, it ensures stability with respect to returns and risk ratios. Compared to them, ELSS funds that have a high concentration in mid or small-cap stocks tend to be more volatile.
As a result, they usually carry high risks as well. However, investors who prefer high potential returns may choose them.
It is a good idea to look for an ELSS fund with a low expense ratio. This is because a high expense ratio reduces returns from your investment.
Financial experts recommend choosing a fund that has performed well consistently for the previous 5 to 10 years. It is also a good idea to compare the fund’s performance with its competitors and the underlying benchmark.
If a fund has outperformed its competitors and benchmark, it may be efficiently managed and capable of generating good returns. However, past performance shouldn’t be considered as a benchmark while selecting mutual funds.
The fund manager is wholly responsible for managing a mutual fund. So, it is essential to evaluate the expertise and record of a fund manager before investing. They must have solid knowledge and experience in picking stocks to create a good portfolio.
Evaluating other financial parameters like Standard Deviation, Alpha, Beta, and Sharpe Ratio helps investors make better investment decisions. For example, choosing a scheme with a higher Sharpe Ratio means a high change of getting better risk-adjusted returns.
How to Invest in ELSS Mutual Funds?
Discussed below are the different ways of investing in ELSS mutual funds:
1. Dividend Option
If investors choose this option, they will get the benefit of receiving dividends periodically. Dividends are added to one’s taxable income. However, the scheme generates dividends only in case of excessive profits.
2. Growth Option
Here, investors do not receive dividends periodically. Instead, they will receive the gains during redemption. This facilitates the appreciation of NAV which further leads to profits multiplying. But please remember that returns are subject to market risks.
3. Dividends Reinvestment Option
Under this option, the investor reinvests the dividends he has received. These get added to the NAV. This facility Is beneficial, especially when the market sees upswings.
Tax Benefits of ELSS Funds
According to Section 80C of the Income Tax Act, investors can seek tax deductions on investments up to Rs. 1.5 lakh in ELSS mutual funds.
In total, investors can save Rs.46,800/- annually in taxes on their investments. Please note that there is no maximum limit on the amount one can invest, though there is a cap on the tax benefit.
The capital gains that investors earn from their Equity-Linked Saving Scheme investments are treated like equity instruments when it comes to Income Tax calculations.
Therefore, the applicable tax rate for STCGs (Short Term Capital Gains) is 15%. LTCGs (Long Term Capital Gains) are taxed at 10% if the amount exceeds Rs.1 lakh in a financial year.
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How to Redeem ELSS Mutual Funds?
ELSS comes with a lock-in period of 3 years. However, the redemption works differently for a lump sum and SIP investments. For instance, if you have made a lump sum investment of Rs.10,000/- on 1st December 2021, you can only redeem it on or after 1 December 2024.
However, the process is a bit different when it comes to SIP investments. For SIPs, you invest a fixed amount every month. Hence, the lock-in period applies to all of your monthly investments individually. Let’s understand this with an example.
Let’s say you invest Rs.1,000/- from January 2022 to April 2022 and you receive 100 units every month from your investment. So, for SIPs, January units can only be redeemed after January 2025 (a lock-in period of 3 years). But this won’t be applicable for other months’ investments. You can redeem February’s units only after February 2025 and so on and so forth.
The comparison chart between ELSS and other tax-saving instruments is as follows:
Tax Saving Investment Option
Equity Linked Savings Scheme (ELSS)
10% to 12%
Public Provident Fund (PPF)
7% to 8%
Fixed Deposit (FD)
6% to 7%
National Pension System (NPS)
Till retirement (60 years)
8% to 10%*
National Savings Certificate (NSC)
7% to 8%
*This is the 5-year weighted average returns of NPS Tier-1 schemes. The returns are not guaranteed.
ELSS or SIP – Which Is Better?
Comparing ELSS and SIP is not ideal. This is because these are two crucial but different terminologies associated with mutual fund schemes. While ELSS is an investment scheme, SIP (Systematic Investment Plan) is an investment mode.
The following lists these concepts in more detail:
These schemes allocate 80% of their funds in equity, thus falling under the category of equity mutual fund schemes. Such funds offer tax benefits of up to Rs.1.5 lakh under Section 80C.
A Systematic Investment Plan is an investment mode that enables the investor to invest a sum of his/her preference periodically – monthly, quarterly or annually.
Investors can invest via SIPs in ELSS to receive the maximum benefits. It could help them receive the benefit of systematic tax-saving. It also helps instil financial discipline in them.
Best ELSS Mutual Funds in 2022
The table below illustrates the top-performing ELSS mutual funds of 2022:
Factors to Consider Before You Invest in ELSS Mutual Funds
You must remember that ELSS mutual funds come with a compulsory lock-in period of three years. Therefore, you need to consider your investment duration before the withdrawal. If the scheme allows you to make regular withdrawals, do note that you can only withdraw the money which has exceeded three years from the day you invested.
This is why you need to be particular about your date of the contribution and investment duration before you invest in ELSS schemes.
If investing in equity is your main objective alongside availing yourself of tax benefits, ELSS tax saving mutual funds are worth considering. That said, if your financial goals are not in line with the scheme, you may consider other options available on the Navi. If you want to unlock the power of passive investing, visit Navi Mutual Fund and explore a host of mutual funds
The expense ratio refers to the yearly fee that an asset management company (AMC) imposes on investors to finance the expenses of running the fund. This annual maintenance charge has a direct impact on your net returns. Hence, it is vital to consider the expense ratio of the different ELSS mutual funds when comparing them.
Although investing in ELSS tax saving mutual funds gives significant benefits, for example, tax exemption, there are certain risks involved nonetheless. Therefore, it is of utmost importance that you consider several aspects, such as your risk appetite, investment objective, etc., before investing.
Moreover, you should also take into account the potential market volatility as the consistency and returns of these funds depend on the performance of the stock market.
Frequently Asked Questions
Q1. Can I invest in ELSS funds alongside PPF?
Ans: Yes, you can invest in both PPF and ELSS funds and enjoy tax benefits of up to Rs. 1.5 lakh on the investments made in both these schemes, under Section 80C of the ITA.
Q2. Can I avail tax benefits on ELSS after 3 years?
Ans: After the initial lock-in period of 3 years is over, individuals can avail of tax benefits on ELSS if they re-invest their funds.
Q3. Is it possible to invest more than Rs. 1.5 lakh in an ELSS?
Ans: Yes, it is possible to invest more than Rs. 1.5 lakh in ELSS in a given year since there is no upper cap on the investment amount. It is, in fact, encouraged to invest more than Rs. 1.5 lakh to maximise the tax benefits under this scheme.
Q4. Is it better to invest in a tax-saver fixed deposit or an ELSS?
Ans: It is important to take factors such as risk appetite, expected returns, financial goals, and more into consideration before proceeding to invest in any of these instruments. Individuals with a higher risk appetite and long-term investment goals will find ELSS to be more suitable for their portfolios.
Q5. Is it possible to switch from a regular ELSS to a direct one?
Ans: Switches between regular and direct ELSS are not permitted during the lock-in period of 3 years. You can switch between plans only after this tenure of 3 years is over.
Q6. When should I invest in ELSS funds?
Ans: There is no right time for investing in ELSS funds. You can start allocating your funds to this type of equity-oriented scheme whenever you want. However, you might want to consider holding on to your units for as long as possible to maximise your long-term portfolio value.
Before you go…
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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