ELSS mutual funds: Features, benefits, and investment tips
The primary objective of investing is to create a safety net and potentially grow wealth over time. However, the taxes you pay on your investments eat into your real returns. Thus, it is important to strike a balance between investment avenues that offer high growth potential and those that offer tax efficiency.
An avenue that can offer both advantages is an Equity Linked Savings Scheme (ELSS) mutual fund. Such funds invest predominantly in equities, offering long-term wealth-building potential. Moreover, investments of up to Rs 1.5 lakh in a financial year are eligible for tax exemption under Section 80C of the Income Tax Act, 1961.
The benefits of this tax-saving mutual fund have made it popular among long-term investors. This article will help you understand the features of ELSS funds so you to make an informed investment decision.
- Table of contents
- What are ELSS Funds
- Features of ELSS mutual funds
- How do ELSS funds work?
- Who should invest in ELSS mutual funds?
- How should you invest in an ELSS fund?
- Why should you invest in ELSS tax-saving mutual funds?
- Tax benefits of ELSS Mutual Funds
- Things to consider before investing in ELSS Funds
- What are the risks associated with ELSS Funds?
- How ELSS fund help in growth contribution
- Comparing ELSS with other tax-saving instruments
What are ELSS Funds
ELSS funds are equity mutual funds that invest at least 80% of their portfolio into equities and equity-related instruments. This means your investment is primarily in the stock market.
Equities have historically delivered higher returns in the long term than traditional fixed-income instruments (though it’s important to note that past performance does not predict future outcomes and mutual fund returns are subject to market risk). This gives ELSS funds the potential to outperform inflation and build wealth over time.
Additionally, investments in ELSS funds are eligible for tax deductions under Section 80C of the Income Tax Act, with a maximum deduction limit of Rs. 1.5 lakh per financial year. This deduction can significantly reduce your taxable income, thereby lowering your overall tax liability.
Unlike most other equity mutual funds, ELSS funds come with a lock-in period of three years, during which you cannot access your money. This encourages long-term investing and can make such funds suitable for goals that have an investment horizon of multiple years.
Features of ELSS mutual funds
The following features make ELSS mutual funds a compelling choice for investors seeking tax-efficient growth:
- Equity investments: ELSS funds must invest a minimum of 80% of their total assets in equities and equity-related instruments. This gives such funds high growth potential over time.
- Diversified portfolio: Investments can be spread across sectors and market capitalisations (large-cap, mid-cap, and small-cap). Diversification helps spread risk and mitigate the impact of underperformance in one area on the entire portfolio.
- Tax benefit: Investments of up to Rs 1.5 lakh in ELSS funds are eligible for tax deductions under Section 80C of the Income Tax Act, 1961.
- Relatively short lock-in period: ELSS funds have a mandatory lock-in period of three years. This is shorter than the lock-in periods of other tax-saving investment options. For instance, public provident funds have a lock-in period of 15 years and National Savings Certificate investments have a lock-in of five years.
- Market-linked returns: The returns from ELSS funds are linked to the performance of the underlying equity markets. This means such funds offer high growth potential but also entail high risk.
- Open-ended structure: ELSS funds are open-ended, meaning investors can enter the fund at any time. However, they can only redeem units after three years.
- No upper investment limit: There is no maximum limit on the amount you can invest in ELSS funds. However, the tax deduction under Section 80C is capped at Rs. 1.5 lakh. This is a combined cap for all investments done under Section 80C. So, you may invest that amount in ELSS alone, or more than one avenue.
How do ELSS funds work?
ELSS funds, like all mutual funds, pool investments from various individuals and invest the money in a diversified basket of securities, most of which are equity and equity-related instruments. Skilled fund managers conduct thorough market research and analysis to select stocks with growth potential. They also manage the portfolio, buying and selling securities when needed.
The primary objective of these funds is to generate long-term capital appreciation for investors by tapping into the growth potential of the stock market.
Who should invest in ELSS mutual funds?
ELSS mutual funds can be suitable for a wide range of investors, including the following types:
- Salaried individuals: ELSS funds offer a way to diversify your investments and potentially earn higher returns through exposure to the equity markets. Moreover, ELSS funds offer systematic investment plans (SIPs), wherein you can invest a fixed amount at regular intervals (daily, weekly, monthly, etc). This can make investing affordable.
- First-time investors: ELSS funds can provide an entry point into equity investing and mutual funds. Regular investing through SIPs can be a convenient way for beginners to start investing with smaller amounts.
- Taxpayers seeking long-term growth: ELSS funds can be a suitable option for those seeking tax deductions under Section 80C while aiming for long-term wealth creation.
- Investors looking for diversification: If you have a predominantly fixed-income portfolio, ELSS funds can add a layer of diversification.
How should you invest in an ELSS fund?
Investing in an ELSS fund involves a few simple steps:
- Choosing a scheme: Research and select an ELSS fund. Consider factors such as the fund's past performance, expense ratio, investment strategy, and fund manager's track record.
- Decide how to invest: There are two primary ways to invest in ELSS funds.
- Lumpsum: You make a one-time investment, typically a large sum.
- SIP: Invest a fixed amount at regular intervals (monthly, quarterly, etc.).
- Investment platforms: Once you select an ELSS fund, you can visit the website of the asset management company that runs the scheme. You can also invest online or offline through the asset management company, distributors or aggregator platforms.
Why should you invest in ELSS tax-saving mutual funds?
Here are some reasons you should consider investing in ELSS tax-saving mutual funds:
- Tax saving: By investing in ELSS, you can claim deductions up to Rs. 1.5 lakh under Section 80C of the Income Tax Act.
- Low minimum investment amount: ELSS mutual funds allow investments for as low as Rs. 500 as required under Income Tax Act. 1961.
- Flexibility of SIP investments: Alongside lumpsum investments, ELSS funds offer the convenience of SIPs.
- Continued investment after lock-in: After the three-year lock-in period, you have the flexibility to either redeem your investments or continue to stay invested.
Tax benefits of ELSS Mutual Funds
ELSS mutual funds stand out as a tax-efficient investment avenue, offering distinct advantages under the Indian Income Tax Act:
- Deduction: Investments in ELSS funds are eligible for tax deductions under Section 80C. Apart from this, profits earned on ELSS investments are eligible for long-term capital gains (LTCG) tax, which is more favourable than short-term capital gains tax. This is because there is a mandatory three-year lock in. LTCG tax is levied on equity investments held for a year or more. The 2024 Union budget has proposed that the LTCG tax rate be increased from 10% to 12.5% (plus applicable surcharges and 4% cess). It has also raised the exemption limit from Rs. 1 lakh to Rs. 1.25 lakh.
- In comparison, short-term capital gains (STCG) tax is levied on equity investments held for less than a year and the tax rate has been increased from 15% to 20% in the 2024 Budget.
Things to consider before investing in ELSS Funds
Here are the factors you should consider so that your investments align with your financial goals and risk tolerance:
- Fund returns and performance: Compare the fund's historical performance with its benchmark and peers. Do note, however, that past performance may or may not be sustained in the future.
- Expense ratio: The expense ratio is the percentage of your invested amount that goes into covering the fund’s operational costs.
- Financial parameters: Look at risk metrics such as standard deviation (measures volatility), Sharpe ratio (risk-adjusted returns), alpha (excess return compared to the benchmark), and beta (measures sensitivity to market movements).
- Fund manager's expertise: Research the fund manager's experience, investment philosophy, and track record.
What are the risks associated with ELSS Funds?
Like all market-linked investments, ELSS funds come with certain risks. These include:
Market risk: ELSS funds are equity-based, meaning they are exposed to market volatility. Price fluctuations can cause losses, especially in a market downturn.
Fund manager risk: ELSS fund performance relies on the manager’s decisions. A change or poor performance from the manager can affect returns.
Inflation risk: Real returns may be eroded if a fund's growth does not outpace inflation.
How ELSS fund help in growth contribution
- ELSS funds are equity-linked mutual fund schemes that invest primarily in equity and equity-related securities. These funds offer tax benefits under Section 80C of the Income Tax Act, 1961 making them a suitable option for investors looking to save taxes.
- Apart from tax benefits, ELSS funds also offer the potential for capital appreciation due to their equity exposure. ELSS funds invest in a diversified portfolio of stocks across various sectors and market capitalisations, providing investors with exposure to the broader equity market.
- ELSS funds also offer the benefit of professional fund management, which can help in identifying investment opportunities, managing risks, and generating return potential. ELSS fund managers have the expertise and resources to conduct thorough research, analyse market trends, and make informed investment decisions.
Additionally, by investing in ELSS funds, investors can also avail themselves of several other potential benefits:
- Long-term capital appreciation: ELSS funds have a lock-in period of three years, which encourages investors to stay invested for the long term. Over this period, investors can potentially benefit from the compounding effect of capital appreciation, as the value of their investments grows over time.
- IDCW: Some ELSS funds also provide regular Income Distribution Cum Capital Withdrawal (IDCW) pay-outs to investors. These can be reinvested or used as a source of income, further enhancing the growth potential of the investment. However, reinvestment will result in further lock-in period for 3 years. Also, the NAV will fall to the extent of IDCW payouts and statutory levy, if any.
Comparing ELSS with other tax-saving instruments
While several tax-saving instruments are available in the market, ELSS funds distinguish themselves through their unique blend of growth potential and tax efficiency. Let's compare ELSS funds with other popular tax-saving options:
Parameter | ELSS | Public Provident Fund (PPF) | National Savings Certificate (NSC) | 5 Year Tax-Saving Fixed Deposits |
---|---|---|---|---|
Type of investment | Mutual Fund (Equity) | Government Scheme | Government Scheme | Bank Fixed Deposit |
Lock-in period | 3 years | 15 years | 5 years | 5 years |
Risk level | High | Low | Low | Low |
FAQs
What are ELSS mutual funds?
ELSS (Equity Linked Savings Scheme) are diversified equity mutual funds that offer tax benefits under Section 80C of the Income Tax Act, 1961. They invest predominantly in equity and equity-related instruments, aiming to generate long-term capital appreciation.
Is ELSS risk-free?
No, ELSS funds are not risk-free. As they are equity-oriented, they carry market risks similar to direct equity investments. Hence, they are suitable for a relatively long investment horizon to mitigate the impact of short-term volatility.
What is the lock-in period in ELSS mutual funds?
ELSS funds have a mandatory lock-in period of 3 years. This means you cannot redeem your investments before the completion of this period.
How to invest in ELSS through SIP?
You can invest in ELSS through a Systematic Investment Plan (SIP) by choosing an ELSS fund, deciding on the SIP amount and frequency (monthly, quarterly, etc.), and setting up an automatic debit from your bank account.
What is the maximum tax benefit that can be availed by investing in ELSS every year?
The maximum tax benefit that can be availed by investing in ELSS every year is up to Rs. 1.5 lakh under Section 80C of the Income Tax Act. However, the actual tax saved will depend on your income tax slab.
Is PPF better than ELSS?
The choice between PPF and ELSS depends upon several factors, including your investment horizon, risk appetite and liquidity needs. PPF is a government-backed investment and is considered to be relatively safe. It also offers tax-free returns and tax exemption under Section 80C of the Income Tax Act, 1961. However, it has a 15-year lock-in and lower return potential than equity-oriented schemes such as ELSS funds.
On the contrary, ELSS offers better long-term return potential but comes with high risk. It offers tax benefits on the invested amount, but returns are subject to capital gains tax. With a three-year lock-in period, it is more liquid than PPFs.
Which mutual fund is suitable for tax saving?
ELSS is the only mutual fund that offers tax benefits under Section 80C of the Income Tax Act. Up to Rs. 1.5 lakh invested in all eligible schemes under this Section can be deducted from the investor’s taxable income. To select a suitable scheme within the category of ELSS funds, you can look at the asset management company’s track record, fund manager’s credentials, expense ratio and investment approach. Consulting a financial advisor is recommended for major investment decisions.
Is ELSS good or bad?
The suitability of an ELSS fund depends upon an investors’ risk appetite and investment horizon. ELSS funds offer tax benefits and long-term growth potential with a 3-year lock-in period. However, they carry market risks and may not suit short-term goals. They may be suitable for long-term investors, and those comfortable with market fluctuations, but unsuitable for risk-averse or short-term investors. They may also not be suitable for those who want high liquidity and no lock-in period.
Does ELSS give better returns?
ELSS funds have the potential to offer better long-term returns than traditional tax-saving options like PPF or fixed deposits due to their equity exposure. However, they come with market risks. Returns are not guaranteed and are subject to fluctuations.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.