Debunking Seven Myths About ELSS in Mutual Funds

Debunking Seven Myths About ELSS in Mutual Funds

An Equity Linked Saving Scheme (ELSS) is an open-ended equity mutual fund that invests primarily in equities and equity-related products. These funds invest at least 80% of the scheme’s assets in equities.
They are a special category among mutual funds that qualify for tax deductions under Section 80C of the Income Tax Act, 1961. As a result, they are popularly known as tax-saving mutual funds.
These funds have the shortest lock-in period of three years as compared to other tax-saving alternatives.

ELSS is a good investment option for those investors who are seeking:

  • Inflation beating returns (through limited equity exposure)
  • Shorter time horizons (36 months)
  • Low volatility
  • High liquidity
  • Tax efficiency

Taxation on ELSS

  • ELSS are entitled to similar tax benefits as hybrid equity funds or balanced funds.
  • Long-term capital gains (LTCG is applicable on a holding period of more than 12 months) in equity savings funds are tax-free up to INR 1 Lakh in a financial year. Thereafter, it is taxed at 10%.
  • Dividends paid by equity savings funds are taxable in the hands of the investor.

Thus, the returns generated from ELSS are taxable with the dividend distribution tax (DDT) and taxes on Capital Gains (LTCG) after the lock-in period of 3 years. However, the investor can claim the tax benefit up to an investment of INR 1.5 lakh under Section 80 C of the Income Tax Act, 1961 through ELSS schemes each year.

Debunking Myths around ELSS

1. The best time to invest in ELSS is at the end of the financial year to save tax.

Many investors invest in Equity Linked Saving Scheme funds at the end of the financial year to save taxes. This may not be considered a good strategy. Tax savings are definitely an essential consideration for investing in these funds. However, it must be the primary reason to consider investing in them. The best way to maximize the benefits of such funds is to support them with a long-term approach. So, identify your investment goals at the beginning of the year and invest accordingly through Systematic Investment Plans (SIPs). Investing all year steadily can help reduce your exposure to market volatility and build wealth over time.

2. ELSS schemes have a threshold investment limit of INR 1.50 lakh/ year.

Since the tax benefit under Section 80C is limited to Rs. 1.50 lakh a year, it is often misconceived that the investment in ELSS must also not exceed that amount in a single financial year. Such restrictions are also seen in other eligible investment options like PPF and the Sukanya Samriddhi Account, wherein the deposit itself has been restricted to INR 1.50 lakh a year.

However, there is no such restriction, and the investors may invest any amount under ELSS in pursuance of their financial goals. However, the tax benefit will be equal to the actual amount invested, subject to the INR1.50 lakh ceiling limit under Section 80C.

3. The investor has to exit the scheme after three years.

A mandatory lock-in period of 3 years doesn't mean that you have to sell your investments as soon as the threshold lock-in period is over. The investor is free to hold onto the ELSS as long as the scheme performs well and is in synchronicity with the investor's goal.

4. One has to invest a lump sum amount in an ELSS fund to take advantage of its tax-saving feature.

There is a misconception that one can only invest a lump sum amount in an ELSS fund, typically at the end of the financial year to seek benefit from its tax-saving features. However, this is far from the truth.

A systematic investment plan, or SIP, can be opted for as it offers the twin benefits of:

  • Reducing the risk of timing the market, in case one decides to invest a lump sum at the end of the financial year at a time when the needs are in a slump.
  • An investor can integrate his tax planning with the overall financial goal in a holistic manner, rather than rushing in for last-minute investments in a bid to save taxes.

5. ELSS is not as attractive as other Tax Saving instruments?

We compare ELSS to other tax-saving instruments such as Tax-Saving FD, National Saving Certificate (NSC), Public Provident Fund (PPF) and National Saving Certificate (NSC) on three key parameters of returns, tax on returns and lock-in period to find the relative attractiveness of ELSS instruments.

Empirical evidence indicates that ELSS instruments generate the highest returns in the tax-saving category of instruments, in the range of 10%-12% vs. 7%-8%, although ELSS comes with some risk inherent to equity investments.

ELSS offers an investor the dual benefits of capital appreciation from investments in equity along with tax savings. One can opt for dividend payouts if one wishes to receive regular income or go with the growth option for capital appreciation.ELSS Mutual Funds do not have an entry or exit load.

Name of Instrument:

  • ELSS
  • Tax-Saving FD
  • National Savings Certificate (NSC)
  • Public Provident Fund (PPF)
  • National Savings Certificate (NSC)

Lock-in Period:

  • ELSS- 3 Years
  • Tax-Saving FD-5 years
  • NSC-5 years
  • PPF-15 years
  • NSC- up to 60 years of age

Returns:

  • ELSS: 10-12%
  • Tax-Saving FD: 6%-7%
  • NSC: 7%-8%
  • PPF: 7%-8%
  • NSC: 8%-10%

Tax on Returns:

  • ELSS: LTCG Tax
  • Tax-Saving FD- Income Tax
  • NSC- Income Tax
  • PPF-No Tax
  • NSC- Partially Taxable

6. Investors should invest in different ELSS schemes.

ELSS is like any other diversified mutual fund, offering ample diversification in a single product. So, investing in a different ELSS every year does not make sense, even from a risk mitigation perspective.

These are like other equity mutual funds that invest in different companies and sectors. Here, the fund manager has the additional benefit of managing the corpus for three years, without any redemption pressure from the investors. Thus, investors should take a consolidated view by looking at the portfolio and performance of a scheme before switching over to a new scheme. This also prevents any fund overlap.

7. ELSS is complex versus its other tax-saving counterparts.

When compared to other tax-saving alternatives such as PPF, and NSC, there is a perception that ELSS is complex. However, ELSS is just like any mutual fund scheme except that it has a three-year lock-in period. Besides, one can begin investing in ELSS with an amount as little as INR 500, making it easy and affordable across socio-economic strata.

 

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