At the end of a financial year, most investors rush to find avenues for tax saving, and that is also the time when ELSS tax benefit comes to the forefront. ELSS funds are tax-saving mutual funds that offer dual benefits of wealth creation as well as tax saving.
As of 31 July 2021, the number of folios in 25 ELSS growth/equity-oriented schemes was recorded at 4,07,746 based on the SEBI’s report on Funds Mobilised and Total Assets. Based on Association of Mutual Funds in India (AMFI) statistics, the ELSS funds discerned net inflows worth Rs. 931 cr. hitting a 10 month high in Jan 2020.
Let us elaborate on different aspects of ELSS mutual funds including how to invest in ELSS.
This article includes:
- What are ELSS funds?
- Types of ELSS funds
- Advantages of investing in ELSS fund
- ELSS vs. other popular tax-saving investments
- How does ELSS Fund work?
- How to make money by investing in ELSS fund?
- Limitations and risks of ELSS fund
What are ELSS funds?
ELSS (Equity-Linked Savings Scheme) funds, popular as tax-saving mutual funds, are professionally run funds that focus primarily on equity and equity-linked securities to generate returns for the investors. A 60-80% of its portfolio is invested in diversified equity and related securities, and the remaining may have exposure to fixed-income securities.
ELSS funds are the only funds with tax deduction benefits that help investors to save on taxes under the Section 80C of the Income Tax Act, 1961. Among all Sec 80C investments used for tax savings, ELSS funds are the only investment with the least lock-in period of three years.
Investors can gain from ELSS funds by investing a lump sum amount or invest via a Systematic Investment Plan (SIP) that offers the additional benefit of cost averaging.
Types of ELSS funds
ELSS funds are classified as:
- Dividend payout funds or Income Distribution cum Capital Withdrawal (IDCW) plans where investors receive tax-free dividends. These funds invest primarily in companies having the potential to give dividend payout consistently.
- Dividend reinvestment funds or reinvestment of IDCW plans where returns or dividends are declared but instead of paying to investors, the dividends get reinvested as a new investment.
- Growth Funds where the investor can realize the full value of the fund at the time of redemption.
Advantages of investing in ELSS fund
ELSS funds are one of the most preferred investments among all Section 80C investments because of the following advantages:
- ELSS funds are the only tax-saving funds with the potential of providing inflation-beating returns as it invests in equity and equity-related securities.
- It offers dual advantages of tax deductions and exemption besides wealth creation.
- It is suitable for an investor with a long-term investment horizon as well as short-term as it is a fund with a lock-in period of just three years.
- The investment does not involve entry and exit loads.
- Investors need not accumulate funds to start investing in an ELSS fund. Start investing with a small amount, as low as Rs. 500 in some funds. The minimum amount for investing varies from fund to fund.
- Superior fund management is a part of the ELSS world where fund managers perform thorough research for long-term strategic decisions in addition to analyzing market-wide trends to provide higher actual returns than expected by investors.
ELSS vs. other popular tax-saving investments
ELSS vs. PPF
ELSS vs. NPS
NPS is exclusively to create a retirement corpus where you need to stay invested for a very long period to generate significant returns. This scheme has delivered 8% to 10% ROI for over a decade. Whereas, ELSS funds can meet the financial objectives of medium to long-term investors with higher equity returns.
How do ELSS funds work?
ELSS mutual funds are investments with specific objectives and levels of risk. It is a diversified approach to investing as it diversifies the investments in a variety of individual securities, primarily stocks of listed companies, according to the investment objective of the fund, thus managing the risk of underperforming securities. The fund managers choose securities from companies of all sizes – large-caps, mid-caps, and small-caps – across industries and sectors, after in-depth research, as they try to deliver maximum risk-adjusted returns from the portfolio.
ELSS funds allow investors to invest through SIP and a lump sum amount. If you want to invest via SIP, it is necessary to consider that each SIP will have a different redemption date after completing three years from the investment date.
ELSS investors are eligible for tax deduction up to Rs. 1.5 lakh under the Section 80C of IT Act. The amount invested is non-taxable. Additionally, long-term capital gains (LTCG) are not taxable if the profit earned from the fund upon redemption is lower than Rs. 1 lakh during a financial year.
If an investor invests up to the maximum threshold of Rs. 1.5 lakh in ELSS mutual funds in a year, they can avail of a tax benefit of up to Rs. 46,800. ELSS funds allow to invest much more than Rs. 1.5 lakhs, but tax benefit will not be available if the investment exceeds that threshold.
How to make money by investing in ELSS?
Maximum returns in maximum duration possible
The redemption of the ELSS fund units is allowed only after the lock-in period of three years. However, they can keep the investment for more than three years. To reap the returns at maximum, investors may choose to remain the funds invested for the maximum duration possible.
Better post-tax returns
Investors can take advantage of tax deductions that ultimately increase returns from funds. Returns from ELSS funds are considered Long Term Capital Gains. Such gains from ELSS up to Rs. 1 lakh are not taxable; if exceeded, the investors are liable to pay taxes at the rate of 10% only on the excess.
Inflation beating returns from the equity market
ELSS, which is the indirect investment in the equity market, has the potential to generate higher returns, unlike other 80C investments – PPF or FDs or other fixed-income investments. Long-term investors can gain at maximum from ELSS funds as they may be able to ride out the short-term volatility in the market.
Limitations and risks of ELSS fund
Investors should consider the following limitations of the ELSS funds before choosing to invest:
ELSS funds are equity-based investments; therefore, their performance is affected by the market movements. These funds carry higher risk due to market volatility but the presence of a fund manager to rebalance the portfolio makes ELSS funds less risky than direct equity investment.
Returns from ELSS are majorly based on equity market performance that can turn the tide within a day. Thus, returns from ELSS funds are not fixed and guaranteed like fixed-income investments.
Investors cannot sell/switch from their funds before the completion of the lock-in period, i.e., 3years.
Performance risk may be the result of the fund manager’s lapse in choosing securities that can impact the fund’s portfolio. The investor will have to bear losses due to such failures.
Increased investment horizon in SIP route
If you choose to invest via SIPs, it will increase the timeframe of ELSS fund investment. You need to be ready to stay invested for six to eight years as every SIP installment you make towards ELSS funds will be invested with a lock-in period of three years.
Investment for high-risk profiles
ELSS fund is not an investment for risk-averse investors. It is suitable for investors open to short-term risk.
For mutual fund investments, an investor does not require comprehensive knowledge of the stock market as these are managed by professional fund houses based on investment objectives. Still, investors should focus on fund details like the portfolio and the expense ratio of the fund, its volatility history, the fund manager’s investment approach also. Further, investors should choose a fund house based on thorough research for its past performance, how reputable it is, how well it has been established and regulated.
Thus, the explanation for how to invest in ELSS funds also includes considering the risk involved. Investors can diversify across more than one ELSS fund based on the fund’s performance over the long term instead of recent performance.
ELSS funds are a popular tax-saving tool aimed at maximizing capital appreciation over the long term through investment in equity and equity-related securities. ELSS funds offer the dual benefit of tax saving up to Rs. 1.5 lakh under Section 80C of the Income Tax Act, as well as provide exposure to the equity market to generate potentially higher returns than other tax saving instruments. ELSS funds have the shortest lock-in period of 3 years.