Considering ELSS for Tax-Saving? Choose Your Schemes Carefully

Being an engineer, some financial concepts in the mutual fund space are alien to him. Recently, he heard his colleagues discuss the investments they had made in Equity Linked Savings Schemes (ELSS) last year and availed the tax exemption under section 80C of Income Tax Act, 1961. When he had to submit his investment declaration proof to the HR department of his company, he considered making an investment in ELSS for tax saving and requested me to guide him through it.

So what is Equity Linked Savings Scheme (ELSS)?

ELSS is a type of diversified equity mutual fund scheme and works like any other open-ended equity fund. As per SEBI's norms, ELSS invests a minimum of 80% of its asset in equity and equity related instruments. ELSS investments qualify for tax exemption under section 80C of the Income Tax Act 1961, so you can claim tax exemption up to Rs 1.5 lakh per financial year.

Most taxpayers evaluate various tax-saving investment options as they get closer to the last quarter of the financial year. However, with limited financial literacy and multiple options available under Section 80C, investors often end up investing in sub-optimal tax-saving options generating lower returns with restricted liquidity that are not necessarily aligned with their financial goals.

Let's take a look at ELSS funds closely and understand few points that you should know before you invest into these funds:

1. Lock-in-period

Have you noticed; among all the Section 80C options, ELSS comes with the lowest lock-in period of just 3 years. Whereas other investment options eligible for section 80C deductions such as National Savings Certificate (NSC), Unit-linked Insurance Plan (ULIP), and Tax-saving fixed deposits come with a lock-in period of 5years. In addition, Public Provident Fund (PPF) holds a lock-in period of 15 years and National Pension Scheme (NPS) is until retirement with limited options for premature withdrawals.

Although ELSS has a lower lock-in period of 3years, it is advisable to consider it as a long-term investment and hold for a period of at least 5-7 years for better returns. The equity market may be volatile in the short-term and you might miss on the long-term capital appreciation.

2. Wealth creation potential

ELSS is an ideal way to begin tax saving with mutual funds and enter the equity market. Since ELSS comes with a lock-in period of 3 years, it gives you an opportunity as an investor to observe and get accustomed with the volatility of the market. This lock-in period allows fund managers to take a long-term view of the market unlike other open-ended equity funds.

Being diversified equity funds, ELSS predominantly invests in equities and equity-linked instruments from across the market capitalization, sectors and themes. Equities as an asset class beat fixed income instruments and inflation by a wide margin over the long term, ELSS funds can generate higher returns compared to other Section 80C fixed income instruments.

Individuals aiming to achieve long-term financial goals (buying a dream home, children's education, their wedding expenses, retirement needs, etc.) and have a longer investment time horizon may consider ELSS funds for tax-saving and wealth creation.

3. Risk factor

The only way to beat the volatility of the market and to make superior returns from equities is by staying invested for longer time.

Most of the new investors are put off by ELSS, as it mostly invests in equities and thus carry higher risk. But, you could minimize the risk by having a long-term investment time horizon. Young salaried individuals who can afford to stay invested for a longer period and have a high-risk appetite may seriously consider investing in ELSS.

Bear in mind that the market risk to ELSS portfolios might differ across ELSS funds. Thus, those with moderate to low-risk appetite should opt for ELSS schemes with a large-cap bias and those with a high-risk appetite can opt for ELSS funds following a Multi-cap strategy or mid/small-cap biases.

4. Tax Efficiency

The section 80C of the Income Tax Act allows you to claim the tax exemption on investment up to Rs 1.5 lakh only per financial year. You need to calculate the amount you would be investing in ELSS funds along with other options like FD, NPS, PPF, EPF, NCS, ULIP, etc. if any, because you cannot exceed the total amount of Rs 1.5 lakh to claim for tax exemption under Section 80C.

The gains you make from equities if redeemed after 1 year of investment are considered as long-term capital gains (LTCG). LTCG on equities of up to Rs 1 lakh in a financial year is tax-free, whereas LTCG exceeding Rs 1 lakh in a financial year is taxable @ 10%.

Having said that, among other Section 80C investment choices, PPF comes with tax-free maturities, whereas interest earned from tax saving FDs are taxable as per the investor's tax slab. And for ULIPs, the entire maturity proceeds are taxable if the premium paid exceeds 10% of the sum assured.

5. financial discipline

Like any other mutual fund category, ELSS also has Systematic Investment Plan (SIP) mode of investment that will provide you the advantage of compounding along with rupee-cost averaging. To survive the tides of volatility in equity markets you may opt for SIP mode of investing. But do note that each instalment via SIP is subject to a lock-in period of 3 years.

SIP enables you to invest a predetermined amount at regular frequencies regardless of the market condition to build a desired corpus over the longer time period. This periodic and automatic deduction of investment for ELSS encourages you to save as well as invest regularly.

Now that you know about the key features of ELSS funds, here are few steps on how to select an ELSS fund:

1. Compare the funds past performance across market cycles and your investment time horizon.

2. Analyse your risk appetite as well as risk ratios and expense ratios for selection of appropriate schemes.

3. Evaluate the portfolio characteristics of the particular fund to understand the investment strategy.

4. Check for the credentials of the fund management team.

5. Analyse the investment systems and processes followed by the fund houses to understand the overall efficiency and check for track record of how well they manage other schemes.

As a result, any selection of ELSS funds should not be based solely on the category of the best performing fund or on past performance. You also need to assess the quantitative and qualitative parameters prudently. In order to benefit from different market phases, most of the ELSS invest across market capitalisation.

Hence, it is vital to select the appropriate ELSS fund in your portfolio in case you decide on a non-worthy ELSS fund, then you will have to bear the cost of underperformance until the lock-in period of 3 years comes to an end.

Therefore, before investing in ELSS fund, be sure you have a longer investment time horizon and a high-risk appetite. If you prudently select the better performing ELSS fund, it can lead to be a rewarding experience on tax saving in the long run.

However if you are not sure about how to exercise your tax planning, save yourself from the last-minute stress and initiate your tax planning with the help of PersonalFN's Definitive Guide to Select ELSS (Edition 2021).

This Guide will show you how picking a worthy ELSS, a tax saving mutual fund, that could potentially maximise your wealth and act as an effective tool for tax planning. It includes:

• Why ELSS is a worthy option for tax planning

• Mistakes to avoid while investing in ELSS

• How to select the best ELSS for tax planning

• How have ELSS performed as a category

• Some of the best ELSS to invest in

• Who should consider investing in ELSS

• How should one go about investing in ELSS

If you are looking to exercise your tax plan and invest in ELSS funds towards the end of FY2020-21, then Subscribe now! To PersonalFN's Definitive Guide to Select ELSS (Edition 2021).

Happy Investing!

Warm Regards,
Mitali Dhoke
Jr. Research Analyst

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