5 things to note about ELSS

By Larissa Fernand |  06-02-19 | 

Everyone wants to pay less tax. But when it comes to the end of the tax season, most run helter skelter and opt for whatever is suggested at that time. We tackled this in The biggest tax planning mistake and What tax saving is not.

If you have been contemplating tax-saving mutual funds, here is a brief primer on what you should be aware of.

It is a mutual fund.

An ELSS is an acronym for Equity Linked Savings Scheme, which is a diversified equity mutual fund.

This is an equity fund which means that a minimum of 65% of the fund’s assets will be invested in the stock market.

Unlike a thematic fund (such as pharma or banking) or a sector fund (such as auto or FMCG), this is a diversified fund that will invest across sectors and industries.

The fund manager will decide predominantly which market cap to invest in. Depending on whether he focuses on large stocks or smaller fare, the fund will take a large-cap tilt or a mid-cap tilt. It could also be a flexi-cap fund if the complexion of the market cap exposure keeps changing.

It offers a tax benefit on investment.

An ELSS provides a tax benefit under Section 80C of the Income Tax Act. Under this section, designated investments are eligible for a tax deduction. Let’s say your total income is Rs 12 lakh. And you invest Rs 1.50 lakh under Section 80C. The total taxable income drops to Rs 10.50 lakh.

There is no maximum investment limit to your investment in the ELSS, however, only amounts up to Rs 1.50 lakh are eligible for a tax break. Having said that, bear in mind that this limit also encompasses other investments and deductions.

It has a lock-in period.

The fund would be open ended, which means you can buy and sell units anytime.  Simultaneously, it has a minimum lock-in period to avail of the tax benefit, which is 36 months or three years. You cannot sell your units before the completion of this period.

If you do a Systematic Investment Plan (SIP), it will be three years from the date of investment. Basically, every instalment will have a 3-year lock-in commencing from the date of that specific instalment. After the lock-in period, you can access your money any time since it is an open-ended fund. So, for the SIP done on, say, March 1, 2018, the lock-in period will be 3 years starting from March. For the instalment made on December 1, 2018, the lock-in period will commence for 3 years from then.

(We wrote about SIPs in tax-saving funds in Don't make this tax-saving errors again.)

Incidentally, all tax-saving investments have a lock-in period. For instance, there are 5-year fixed deposits either at banks or the post office. The National Savings Certificate (NSC) also has a lock-in period of 5 years. The Public Provident Fund (PPF) has the longest lock-in period of 15 years. You can access more information in How to make PPF work for you.

The returns are taxed.

Since these funds have to be held for at least three years, on redeeming the units, long-term capital gains (LTCG) comes into play.

For a number of years, tax on LTCG on equity was nil. The Union Budget of 2018 reintroduced LTCG tax on equity. Investors will now have to pay 10% tax on gains exceeding Rs 1 lakh, made from the sale of equity or equity oriented mutual funds.

Do note the interest on NSC and 5-year deposits is also taxed. The PPF, on the other hand, is a boon in that sense. It has no tax levied upon it.

The returns are not guaranteed.

It is a market-linked product, so there cannot be any guarantee or assured returns. Other tax-saving investments like PPF, NSC, 5-year deposits, post office saving schemes, all have a fixed return. From that point of view, an investment in an ELSS is definitely more risky.

I look at how much a lumpsum investment in a particular fund would yield over 3-year periods.

  • 42%: January 1, 2009 to January 1, 2012
  • 35%: January 1, 2010 to January 1, 2013
  • 49%: January 1, 2016 to January 1, 2019

As with any equity investment, exit when the market is better positioned. Just because you have completed the 3-year lock-in does not mean you HAVE to sell your units. You may have to wait for a while if the market is in the doldrums. Hence with every equity investment, keep a longer term perspective in mind.

Combined with the tax break under Section 80C, ELSS does make for an excellent investment, if you have a low allocation to equity. It has the potential for wealth creation and the likelihood of beating inflation; as interest rates fall, so will the return on fixed-income instruments. An exposure to equity is necessary for investors to meet their goals.

However, exercise caution. You need to choose your fund wisely as there are numerous options available in the market and not all good.

Over the next two days, we shall write on how to select an ELSS and share the views of Morningstar analysts on select funds.

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