Equity Linked Saving Schemes Archives

An Essential Guide to Tax Saving Mutual Funds – ELSS: Whenever you research how to save taxes in India, you can easily find the experts mentioning to invest in tax saving mutual funds or ELSS. However, for beginners, getting started with ELSS investment might be a little confusing.

In this post, we are going to cover everything regarding tax saving mutual funds. By the end of this post, you’ll be able to clearly understand why exactly is an ELSS and how it works.

So, if you are a newbie and find it challenging to get started with tax saving mutual funds in India, then please read this article until the very end. It will definitely help you to demystify the majority of the questions that you might have regarding ELSS. Let’s get started.

1. What is Equity linked saving schemes (ELSS)?

An ELSS (Equity Linked Savings Scheme) Mutual Fund is a variety of Equity Mutual Fund which allows individuals and HUFs to avail Income Tax deduction from their Total Income for an Assessment Year subject to a maximum limit of Rs.1.5 lakhs u/s 80C of the Income Tax Act, 1961.

ELSS mutual fund is an Equity oriented fund which is having a lock-in period of 3 years. The said duration is counted from the respective allotment date of the unit(s).

Like any other type of Equity Mutual Fund, ELSS comes with both growth and dividend options as well.

Investment in an ELSS scheme can either be made in a lump-sum or through a Systematic Investment Plan (SIP). Investments made in a Financial Year (Previous Year) up to ₹1.5 lakhs can be claimed for tax deduction under the said Act.

Till the Financial Year 2017-18, no tax on income from Long-term capital has been charged from an Assessee on redemption of the unit(s) of an ELSS. As per the Budget (Finance Act) 2018, Long-term capital gain over ₹1 lakh is to be taxed @ 10% by the Government of India.

2. Types of ELSS

ELSS comes in two varieties. The first category is the dividend scheme and the second type is the growth scheme.

In the case of former, when the mutual fund announces a dividend, the unitholders earn income in the form of a dividend on the units held by them. Such dividends can either be withdrawn or reinvested by the unitholders.

Another part of ELSS with dividend feature is that the dividend earned is eligible for tax benefits. Moreover, the dividend earned by the unitholder is not subjected to any lock-in period, i.e. it can be withdrawn any time.

A similar provision is not applicable to the growth schemes.

3. What are the features of Tax Saving Mutual Funds?

Image source: Richvikwealth.in

In order to avail the benefit of the tax deduction, an Assessee can make an investment in an ELSS Mutual Fund for as low as Rs. 500. There is no upper limit of investing in ELSS, unlike PPF and NSC, but as said earlier one would only get tax deduction u/s 80C to the maximum of Rs. 1.5 lakh.
Investment in an ELSS scheme is, of course, meant for a long duration as it comes with a lock-in-period of 3 years.
Irrespective of the short lock-in period of ELSS funds, the later have time and again yielded substantially higher returns in comparison to NSC, PPF, ULIP, etc.
ELSS is an equity oriented mutual fund wherein the underlying portfolio majorly consists of equity investments in publically listed companies having strong business models. Being equity oriented mutual fund, it is subjected to market risks.
Tax saving mutual funds or ELSS are mostly open-ended.
Like any other mutual fund, an investor of ELSS can also make another person as his/her nominee.
Like most of the equity funds, many ELSS funds also come with entry and exit loads.
Many investors prefer investing in ELSS funds through the SIP route. It ensures rupee cost averaging that significantly cuts volatility in the stock market.

4. What are the benefits of investing in an ELSS?

Image source: Cleartax.in

Here are a few of the distinguishing benefits of investing in ELSS:

As discussed earlier, a taxpayer can enjoy the benefit of deduction from his/her taxable income (for a maximum of Rs.1.5 lakh).
We all know that Mutual Fund investments are subject to market risks i.e. systematic risks. Market risks can’t be eliminated but the fund manager invests the funds of investors in diversified equities which eliminate the unsystematic risks.
An investor may opt for not withdrawing the investment at all after the end of the 3 years lock-in-period. Holding on the units will result in the growth of the investment and will subsequently yield handsome inflation risk-adjusted return for the investor.
As said earlier, the investor can withdraw any dividend earned as no restriction is there on its withdrawal during the lock-in-period. The restriction of withdrawal is there only in respect of the investment.
ELSS, being an open-ended mutual fund, allows anyone to invest in the same at any time during the year.
One can find popular tax saving avenues like ULIP, NPS, and PPF which offer lock-in period ranging from 6 to 15 years. But, investing in ELSS will reduce the lock-in-period significantly to 3 years only.
In case an investor of ELSS is not having knowledge of the market, he/she can be rest assured that his/her funds will be managed by a qualified fund manager.
It is not necessary that one has to invest in ELSS for only availing tax benefits. ELSS can also be considered as a long-term wealth generation tool. As the lock-in-period is 3 years, one can even think of investing in ELSS for meeting any future financial goal.

5. How is the Capital Gain from an ELSS Fund taxed?

If an investor sells his/her units of an equity mutual fund after a year, tax on long-term capital gains (LTCG) will be applicable.

Up to 31st March 2018 tax charged on the long-term capital gain was nil. But, as per the Union Budget 2018, tax on LTCG of stocks and equity funds were re-introduced. If the long-term capital gain exceeds Rs.1 lakh from the redemption of an equity fund, then tax @10% will be charged on such LTCG.

Again, in the said budget it said that if investors sell their equity mutual funds within a year, they will be required to pay short-term capital gains tax @15% on their returns. The provision regarding short-term capital gain (STCG) tax was there in the Finance Act 2017 as well.

ELSS funds as said earlier, are having a lock-in period for 3 years. So, the gain on an ELSS fund by default comes under the long-term capital gain tax.

Image source: Tflguide.com

6. How to choose the right ELSS fund?

Following key points should be considered by someone who is looking to invest in an ELSS fund:

Looking into the past performance: Past performance does not guarantee future performance of a mutual fund scheme. Looking at historical returns is the initial step of evaluating a scheme. It helps in evaluating the performance of the fund managers over the years.

Age of an ELSS Fund: An ELSS Fund has been in the market for 5 years or more is generally considered ideal for new investors. This is because they generally represent reputed AMCs and have good track records.

Risk of ELSS: Different ELSS schemes come with different risks. An investor should select a specific ELSS Fund based on his/her risk appetite.

Looking at the Expense Ratio: The Expense Ratio refers to the percentage of the fund which an asset management company charges from the unitholders. This is the charge for meeting the cost of operations of the fund.

Assets Under Management (AUM): This is the amount of money which is being managed by a mutual fund scheme. Various types of ELSS Funds have different ideal sizes for AUM.

Checking the Rating of ELSS Fund: Ratings of the ELSS Funds published in a reputed online platform helps a prospective investor to know which fund is the best.

Source: Mymoneysage.in

7. The last few words on ELSS Mutual Funds

With the rise in the equity market over the years, the investors have gained interest in ELSS mutual funds as an income tax saving instrument. ELSS is a category of equity mutual fund that is created by the government to encourage people at large to participate in the equity market of India.

As ELSS funds come with the benefit of the tax deduction, middle-aged people feel interested to invest in the major part of their savings in the Indian equity market.

There is no doubt in saying that investing in an ELSS scheme is certainly not risk-free. Even though the NAV graph of an ELSS scheme is not free from frequent ups and downs, the growth of the fund never falls below other tax saving alternatives like PPF and ULIP.

But, owing to a fact of scope for higher returns at a minimum lock-in period, Equity Linked Saving Schemes have emerged as the most demanding tax saving option today.

Equity Linked Saving Schemes or ELSS Fund is a variety of Equity Mutual Fund where the majority of the corpus is invested in equities and equity-oriented instruments. It is a tax saving Mutual Fund where your investments are locked in for 3 years.

ELSS are multi-cap equity funds which invest at least 4/5^th of their assets in equities. Such stocks could be small-caps, large-caps, or mid-caps. ELSS funds can invest in the companies of any sizes. Apart from investing in the stocks of private companies, these funds also invest in the Government undertakings to a significant extent.

Note: If you are new to ELSS, you can read our previously published article here.

ELSS: A tax saving instrument

Previously people used to find FD, NPS, PPF, and ULIP as effective tax saving schemes. Nowadays, the taxpayers are feeling more interested in investing their savings in ELSS funds for availing tax benefit.

ELSS is not only having the lowest lock-in period but it also yields higher returns than the other conventional tax-saving instruments. If you are going to redeem your ELSS investments after 3 years, your capital gain will be taxed @ 10% if it crosses Rs 1 lakh.

As per section 80C of the Income Tax Act, 1961, you can get the benefit of tax deduction in a financial year up to Rs 1.5 lakhs. ELSS or Equity Linked Saving Scheme is a prescribed instrument under the said section. So, you can easily save your tax liability up to Rs 46, 800 (Tax plus Cess on such Tax).

Investing in ELSS for generating long-term wealth

If you are looking to create long-term wealth but willing to accept the risk, let me tell you that equities or equity-oriented funds are the best for you. Equities can fetch you substantial returns if you are willing to stay invested for the long term.

You can choose any form of Mutual Fund i.e. a small-cap fund, large-cap fund or a mid-cap fund. But, neither of the funds can provide you with tax benefits which ELSS can give. Moreover, if the markets seem to be bearish or moving sideways in the short run, you might feel like redeeming your units immediately.

If you have invested in ELSS, you can’t withdraw your investments before the expiry of three years. In that way, investing in ELSS ensures that you stay invested for a long-term irrespective of short-term volatility. So, if you are interested in staying invested for a considerably long period of time, ELSS is definitely an ideal investment option for you.

Should you go for only one ELSS or multiple?

In an ELSS fund, the underlying portfolio consists of around 70 to 100 stocks. Around 5,000 stocks are listed in the Indian markets. Out of such stocks, the top 250 of them contributes towards 90% of the total market capitalization. So, if you are investing in 6 ELSS funds, it means you are indirectly investing in around 600 stocks. This implies that you will end up investing in the stock market as a whole. Therefore, you are virtually removing all possibilities to beat the stock market.

Investing in excessive ELSS funds means you are indirectly looking to form a market portfolio. So, if you are looking to earn what a market index earns, you can opt for such a portfolio. It is highly probable that you won’t earn more than what the market earns but you are also not going to earn less than the same.

There is another limitation of investing in too many ELSS funds. Investing in an excessive number of ELSS will lead to portfolio overlapping. It means that you will be investing in the same stocks through multiple schemes. This would unnecessarily increase your expense ratio instead of yielding the benefit of diversification.

Well, if you are simply looking to invest in the market portfolio, you should consider investing in an Index Mutual Fund or an Index ETF. Through the passive funds, you will be investing in the market indices at a lower cost.

Let us discuss how the situation might look like if your portfolio consists of a single ELSS. If you own only one ELSS fund, it indicates that you have not diversified your investments at all. It seems to be a risky portfolio as you will be exposing it to the risk of underperformance of the Fund Manager. It is of no doubt that you have a higher chance of beating the market if the underlying assets of your scheme consist of top-performing stocks. But, if the market witnesses a downfall, your portfolio will crash down at a higher rate.

An ideal number of ELSS funds for your portfolio

Now, if you ask how many ELSS funds you should have in your portfolio, the ideal number could be either two or three. An ELSS fund is a multi-cap equity fund. Therefore, if you have chosen two to three ELSS funds in your portfolio, you can certainly form a strong portfolio in all possible ways.

Through a single ELSS fund, it is not possible for you to cover a substantial number of top equities. The likeliness increases if you add one or two more ELSS funds in your armory. If your investments can be spread across a good number of profitable stocks, you are going to make significant returns in the days to come. Although your portfolio expenses in the form of equity ratio will go up, the returns are high enough to cover the same comfortably.

We have discussed earlier that too many funds would lead to portfolio overlapping. But, you would not experience the same if you create your portfolio with two to three funds. Investment in a limited number of schemes is not going to capture the major portion of market capitalization. Therefore, you are not forming a portfolio which can replicate the market. So, whatever you will be earning will supposedly beat the market.

Closing thoughts

No assurance can be given whether a portfolio consisting of two to three ELSS funds can alone serve all your wealth generation and tax-saving requirements. Forming a portfolio for an individual is dependent on several factors. If you are an investor with a high-risk appetite you can team up a small-cap equity fund with a ULIP. On the other hand, if you are highly risk-averse, you can go for a debt fund with a PPF.

Through this article, we have tried to give you a general idea regarding the number of ELSS funds which should be there in your portfolio. If you are seeking an investment option which combines wealth creation and tax saving, ELSS is your answer. Otherwise, if you have any specific requirements with respect to profitability, liquidity, and tax benefit, you are free to create your own portfolio accordingly.