Elss / Tax Saver Mutual Funds

What is an ELSS/Tax Saver Mutual Fund?

An ELSS fund or equity-linked savings scheme is the sole mutual fund eligible for tax rebates per the rules of Section 80C of the Income Tax Act. Any investment made in an ELSS fund is eligible for tax deductions up to a limit of Rs. 150,000 in a financial year, which can help you save up to Rs. 46,800 in taxes each year.

This mutual fund type primarily invests in equity-linked options. An ELSS fund allocates up to 80% of its investment corpus in equity-linked investment options like listed share options. Some ELSS mutual funds also have a fair amount of exposure to alternatives like fixed-income securities. Further, these options also come with a lock-in period of 3 years, which is the shortest among all tax-saving investment schemes.

Types of ELSS/Tax Saver Mutual Funds

There are two main types of ELSS Mutual Funds: Dividend ELSS Funds and Growth ELSS Funds. Under the Growth ELSS funds option, the returns gained are not distributed to the investors but reinvested into the same fund. Whereas, in the case of Dividend ELSS funds, the fund house pays out the returns generated as dividends to the investors at regular intervals. The profit is distributed only if and when the scheme generates profits.

Benefits of ELSS/Tax Saver Mutual Funds

In addition to providing the obvious tax-related benefits, ELSS/Tax Saver mutual funds have various benefits which make them an ideal investment option:

Higher Rate of Returns

Since ELSS funds are a predominantly equity-linked investment option, they can deliver potentially higher returns throughout the investment tenure. If you choose to stay invested for longer periods, you can generate and accumulate wealth steadily. ELSS have typically demonstrated a higher return rate than other Section 80C investment options like NPS or PPF.

Inculcates Discipline in Investment

The investments are in relatively safer hands since a professional investment expert manages the ELSS fund portfolio and is well-versed in market behaviour and characteristics of the capital markets. An investor with little or no experience can still invest in top ELSS funds and gain high returns. Thai professional management can help the investor get enhanced security and returns compared to other investment options.

Tax Benefits

The main advantage associated with an ELSS fund is the linked tax benefit. In an ELSS scheme, the investor can claim tax deductions for investments up to Rs. 150,000. You can claim these tax benefits per the provisions of Section 80C of the Income Tax Act and reduce your tax liability for the fiscal year.

Short Lock-in Period

ELSS funds come with a lock-in period of 3 years, which is the lowest among all other tax-saving investment options. It means that the investor can redeem or withdraw their investment in a comparatively shorter period. Other tax saving instruments like National Pension Scheme, National Savings Certificates, and Public Provident Funds come with a longer lock-in period.

Portfolio Diversification

The investment portfolio of an ELSS fund comprises balanced capital allocation to diversified asset classes like debt and equity securities. Further, ELSS funds also diversify within their debt and equity assets, dividing between large, small, and mid-cap options. Investor can diversify their investment portfolio and effectively negate the market risk through the ELSS fund option.

Who Should Invest in ELSS/Tax Saver Mutual Funds?

Even though anyone can invest in an ELSS/Tax Saver fund, it proves to be an ideal investment choice for:

Individuals With an Appetite for Risk

It is imperative to know that ELSS funds mainly invest in equities, a relatively volatile asset class. ELSS may be the right investment option if you have a high-risk appetite and are not averse to volatility. On the other hand, if you are inclined more towards safer investment options, you should consider other investment options rather than ELSS funds.

High Tax Bracket Individuals

If you fall under a high tax bracket and have a surplus investible per Section 80C of the Income Tax Act, ELSS funds can help you reduce your tax liability significantly. According to various financial experts, an individual falling in the highest tax slab can save as much as Rs 47,000 in taxes in a fiscal year.

Investors With a Longer Investment Horizon

An ELSS fund is the ideal investment tool for individuals who can stomach the high risk and have a longer investment horizon. You can effectively and conveniently negate the volatility and risk in an ELSS by staying invested for a longer period, for at least 8 to 10 years.

How do ELSS/Tax Saver Mutual Funds Work?

ELSS mutual funds are diversified equity-linked investment options. These funds typically invest in share options of listed companies in a specific percentage per the investment objective of the fund. The stock options are picked from across market capitalisation and market sectors. The main objective of these funds is to maximise capital generation over a longer investment tenure. The fund manager carefully selects the share options after conducting a detailed market analysis to deliver the best risk-adjusted returns.

Things to Consider Before Investing in ELSS/Tax Saver Funds

Given below are a few things an investor should consider before investing in an ELSS/Tax Saver Mutual fund:

Investment Objective

Before you make the final decision about your ELSS investment, it is important to determine if your investment objectives are on par with the investment objectives of the ELSS investment fund. For instance, if you are investing in an ELSS fund to build a sizable corpus to finance your children’s higher studies, the investment fund in question should also have a medium investment horizon to meet the financial needs.

Risk of the Fund

The associated risk of the ELSS fund is one factor you should consider before making a decision. Since these funds are predominantly equity-linked options, they come with a high-risk possibility. An ELSS scheme that invests in mid or small-cap equities will be riskier than funds investing in large-cap stock options. It is important to consider your risk appetite before you make your investment decision.

Fund’s Expense Ratio

The expense ratio of the fund is one of the most crucial factors an investor should look at before making an investment decision. It usually includes charges like fund manager’s fees, distributors’ commission, auditing and advertising charges, registration fees, etc. It is important to choose an ELSS fund with a low expense ratio.

ELSS Mutual Fund Taxation

As mentioned above, investments in an ELSS fund are tax deductible up to a limit of Rs 1.5 lakhs in a financial year. Let’s take a look at this with the help of an example:

Let’s say Ms Sum Yung Ho has a disposable taxable income of Rs. 2 lakhs in a financial year, and she decides to invest that amount in a Long Term Equity Fund. Only Rs 1.5 lakhs from that investment will be eligible for a tax deduction, reducing your tax liability for the year. Please note that this is only applicable if you have no other tax-saving investment allowed under Section 80C of the Income Tax Act.

Further, the returns earned from an ELSS fund are also subject to capital gains taxation. However, because the units from this investment cannot be redeemed for 3 years, the capital gains tax is only 10% on returns earned above Rs. 1 lakh.

Let’s assume that Mr Finn Garrin Diaz received a capital gain of Rs. 1.5 lakh from an ELSS fund at the time of redemption. The long-term capital gains tax would be levied on Rs. 50,000 for the financial year. If the investor has not made any investment for tax deduction under Section 80C, they can make a lump sum investment in ELSS funds during tax filing and reduce the tax liability.