ELSS Mutual Funds – Meaning, Tax Benefits & How to Invest

ELSS or Equity Linked Savings Scheme are tax-saving mutual funds in India. They combine the benefits of equity investments with tax deductions under Section 80C. ELSS has a 3-year lock-in period, offering the potential for high returns and tax savings, making it a popular choice for long-term investors.

Features of Equity Linked Savings Scheme mutual funds

Some of the features of ELSS mutual funds include:

• Lock-in period: It comes with a minimum lock-in period of 3 years.
• Equity exposure: It invests at least 80% of the investment in equities.
• Tax saving: Investments in ELSS are eligible for tax deduction under section 80C, upto Rs 1.5 lakh.
• Market-linked returns: It offers you market-linked returns, and the performance depends on the performance of the underlying equities in the portfolio.
• Diversified Portfolio: ELSS funds typically invest in diverse equities from various sectors, thereby decreasing concentration risks.

How Do ELSS Mutual Funds Work?

Equity Linked Savings Scheme are diversified equity funds. These funds primarily invest in stocks of listed companies. The stocks are chosen from across market capitalisation (large, mid, and small caps) and sectors. These funds aim to maximise capital appreciation over the long run. The fund manager picks stocks after conducting in-depth market research to deliver optimal risk-adjusted portfolio returns.

Investments made in an ELSS fund are eligible for tax benefits under Section 80C of the Income Tax Act, 1961. While there is no upper limit to the amount that can be invested, a maximum of Rs. 1.5 lakh is eligible for a tax deduction as per the IT Act. By investing this amount in an ELSS, one can save up to ₹46,800 a year in tax outgo.

Tax benefits of ELSS Mutual Funds

ELSS mutual fund is the only category of mutual fund that comes with the tax benefit. Let’s understand in detail about the ELSS tax benefits:

• As per the Income tax rules, investments in Equity Linked Savings Scheme are eligible for tax deduction under Section 80C. You can claim a deduction of upto Rs 1.5 lakh for investment in Equity Linked Savings Scheme and save tax upto Rs 46,800.
• As it comes with a lock-in period of 3 years, you can not redeem it before 3 years. Hence, when you redeem your ELSS funds, you must pay long-term capital gains tax at 10%. But, if the gain is within the limit of Rs 1 lakh, then there is no tax.

Who Should Invest in ELSS Mutual Funds?

• Salaried Individuals: If you are a salaried employee, you would likely be contributing towards the Employees’ Provident Fund (EPF), which is a fixed-income product. If one wants to generate higher returns on one’s investment portfolio, then ELSS is a suitable option. Apart from providing good returns over the long term, investments in ELSS are also eligible for tax deduction under Section 80C. While unit-linked insurance plans (ULIPs) and the National Pension System (NPS) also do the same, they have a higher lock-in period and lesser potential for returns. For instance, ULIPs have a lock-in period of five years. NPS is more of a retirement solution with partial exposure to equity and the invested amount is locked till the age of 60 years. With an ELSS fund, you have the shortest lock-in period of only three years.
• First-time investors: If you are a new investor, ELSS is an ideal choice, since, in addition to tax benefits, you get a flavour of equity investing and mutual funds. Yes, equity investments do carry a higher risk, but that is generally over the short term due to the volatility involved. If you invest for more than five years, the risk is much lower. Like all equity investments, the best way to start investing in an ELSS is through monthly SIPs. SIPs in an ELSS fund help you accumulate more units when the market is in the red and generate good returns when the markets are favourable.

Things to Consider Before Investing in ELSS Funds

• Fund returns: Before you go for a fund, compare its performance with its competitors and the benchmark to know if it has beaten them consistently in the past. Of course, no fund can be at the top all the time, but good funds tend to appear in the top quartiles for extended periods.
• History of the fund house: It is recommended to choose fund houses that have performed well consistently over a long period, say five to 10 years.
• Expense ratio: The expense ratio depicts how much of your investment goes towards managing the fund. If a fund has a lower expense ratio, it means you can have higher take-home returns, so it’s always better to go for such funds.
• Financial parameters: You can also consider several parameters such as the standard deviation, Sharpe ratio, alpha and beta to analyse the performance of a fund. A fund with a higher standard deviation and beta are riskier than one with a lower deviation and beta. Choose funds with a higher Sharpe ratio.
• Fund manager: The fund manager plays a key role in managing your funds. He/she should be competent and experienced in picking the right stocks and creating a strong portfolio.
• SIP or Lumpsum:Before making the investment in ELSS, you should also consider which mode you want to invest in, either SIP or lumpsum. Under the SIP method, you can invest a regular amount periodically, typically monthly. However, under lumpsum method, you invest a huge sum of money in one go. Generally, SIP mode is considered the best option as it gives you the advantage of cost averaging, wherein you receive higher units when the market is down and lower units when the market is up. But if you have surplus money, you can also prefer to invest via lumpsum.

Comparison of ELSS With Other Tax-Saving Instruments

There are other tax-saving instruments in the market that help you earn better returns with tax saving. Returns on these investments are restricted to fixed returns that may not be able to beat the inflation effect. However, this is not the case in ELSS, as it invests equities with a strong potential for good returns, which can beat inflation. Also, it is the only tax-saving scheme with the lowest lock-in period of 3 years.

Here is a quick comparison between ELSS and other tax-saving instruments:

Type of Investment

Mutual Fund (Equity)

Bank Fixed Deposit

Moderate to High

7.1% (Keeps changing)

7.7% (Keeps changing)

Tax Deduction Limit (Section 80C)

Advantages of ELSS Mutual Funds

Here’s a look at the advantages of ELSS Mutual Funds:

Shortest lock-in

ELSS has the shortest lock-in period of three years. Tax-saving fixed deposits have a five-year lock-in, while the PPF has a 15-year maturity. All in all, ELSS offers more liquidity as compared to traditional tax-saving instruments.

Higher returns

Investing in ELSS funds can offer significantly higher returns in the long run than most other tax-saving investment options. ELSS funds serve a dual purpose: tax saving along with wealth creation. Let’s look at how much returns you can earn with ELSS funds in the long term.

ELSS funds, on average, have generated 15% returns in the long term. If you get 15% returns from your ELSS investments, a monthly investment of Rs. 12,500 for 20 years will help you accumulate Rs. 1.89 Crores in the corpus. We calculated the ELSS category’s seven-, 10- and 15-year average rolling returns on a daily basis.

Rolling returns on a daily basis since the inception of tax-saving schemes

The category, on average, has given the highest returns of over 21% in the 15-year period. While we have calculated the average returns of the category, it is pertinent to note that if you had selected a top-performing scheme in the category, you would have earned even higher than the category’s average returns. You can use the ELSS maturity calculator to know the corpus you would have accumulated by investing in different ELSS schemes available.

Better Post-Tax Returns

If your total capital gain in the financial year of withdrawal exceeds Rs 1 lakh, the long-term capital gains (LTCG) from ELSS mutual funds will be taxed at only 10%. If your total profit in a financial year is less than Rs. 1 lakh, you don’t have to pay any long-term capital gains tax.

Convenient

Investing in ELSS mutual funds is a great way to save taxes, even if you don’t have a lump sum amount to invest. With systematic investment plans (SIPs), you can invest a fixed sum each month on a predetermined date in the ELSS mutual fund scheme of your choice. This encourages the habit of saving and provides a sense of discipline without requiring a large investment at the end of the fiscal year.

You can use mutual fund apps such as ET Money to invest in tax-saving mutual funds within two minutes, saving you the hassle of paperwork during the busy tax season.

If you can tolerate market fluctuations, then you should have a higher exposure to equity (ELSS) because it provides better long-term returns, which are essential for building a healthy corpus. Equity can potentially beat inflation and create wealth over the long term. Remember, investments should be made based on goal requirements and asset-allocation suitability rather than just for tax purposes, and ELSS funds satisfy all three criteria.

Tax Implications on ELSS

Capital gains from ELSS get the same treatment in the income-tax calculation as the rest of the equity instruments. Short-term capital gains (STCG) attract a tax of 15%, while long-term capital gains (LTCG) are taxable only if the gains exceed ₹1 lakh during the financial year. Long-term capital gains attract a tax of 10 per cent on the amount exceeding ₹1 lakh.

How to Invest in ELSS Funds

• Growth option: When you go for the growth option, you will not receive benefits in the form of dividends. As an investor, you will get the gains only at the time of redemption. This helps in the appreciation of the total NAV and thus, the profits multiply. There’s one thing to keep in mind – the returns are subject to market risk.
• Dividend option: Under this option, an investor gets benefits from time to time in the form of dividends. However, do note that these dividends are taxable as per your tax slab. Plus, dividends over Rs 5,000 are subject to a TDS (tax deducted at source) of 10%.
• Dividend reinvestment option: This is an option under which an investor reinvests the dividends received to add to the NAV. This works well, particularly when the market is witnessing an upswing and is likely to continue the same way.

Top-Performing ELSS Funds

Choosing a fund can be tedious. The right way is to analyse and compare different parameters across funds before finalising one. That’s not all – investing in a fund depends on an individual’s financial goals, investment horizon, and risk appetite. The following table shows the top-performing ELSS funds based on the past three years’ returns.

*Last updated as on 5th Sep 2024