Tax-saving Mutual Fund Schemes

Equity Linked Savings Scheme or ELSS is a mutual fund scheme which offers the best of both worlds: Long-term wealth creation & tax saving.

tax saving mutual fundELSS serves as one of the best options for your goal of wealth creation and also acts as an effective instrument for tax saving.

As the name suggests, ELSS is an equity-oriented mutual fund scheme.  In an equity-oriented mutual fund scheme, the majority of holdings in the scheme’s portfolio would be in the form of shares issued by companies. This means that it enjoys all the benefits of mutual funds & you also have the option of selecting your preferred mode of investment i.e. lump-sum, SIP or STP. Also, being an equity fund, it has the possibility of giving the highest returns over time. The only difference between ELSS and other equity mutual funds is that ELSS has a lock-in period of 3 years.

The lock-in period means that you can withdraw you investment only after it has been invested for at least 3 years, not before that. An important point to understand here is that lock-in applies to the number of units you purchased and not the invested amount.

Say you invested 60,000 on 3rd March 2014. If the NAV was 60 on that day, you bought 1000 units. Now you invested another ₹50,000 on 2nd August 2014, when the NAV was ₹50, so you got 1000 more units. Let’s say that you want to withdraw on 4th March 2017, when the NAV is ₹90. Since only the first investment has completed 3 years you are eligible to withdraw ₹90,000 (1000 units @ NAV of ₹90). You can not redeem the other 1000 units because their 3 years are not up yet.

If you invest via SIP or STP route each entry will be treated as a fresh investment and will be locked-in for 3 years accordingly. Redemption will be on first-in first-out basis. This should not be the deciding factor however because while investing in equity you should always think long term.

ELSS mutual fund schemes help in long term wealth creation because you buy and hold your equity investment for a minimum of 3 years. This is a reasonable period for compounding to start working its magic. Also, it prevents you from acting on short-term volatility as you are not allowed to withdraw money. ELSS help in establishing financial discipline in an investor. Apart from this, fund managers are also not worried about redemption of corpus which helps them in creating a better portfolio.

Keep in mind that after the 3 year minimum period you don’t have to withdraw the money if you feel that your investment is growing at a good pace. In fact whenever you invest in equities your investment horizon should be at least 5 – 7years. 

As a Tax-saving instrument

Income Tax department offers few tax rebates if you invest your money in any of their pre-defined vehicles. ELSS is one such eligible option for tax saving under Section 80C of the Income Tax act (other eligible deduction under section 80C are Life Insurance Premium, Home Loans, PPF etc). Section 80C allows a maximum deduction of 150,000 from your taxable income in a financial year.

In other words one can avail a maximum deduction of 150,000 from his/her income if they invest the said amount in ELSS funds during any financial year. Keep in mind that there is no upper limit on the amount that you can invest in ELSS in a financial year, but only 150,000 would be eligible for deductions from a tax saving point of view.
Moreover, long term capital gains tax on equity mutual funds is NIL. Since, there is a 3 year lock-in period for ELSS, all returns are tax free.

Some more important points which show that ELSS is a great tax saving option:

  • All tax saving vehicles come with a lock-in period, among them ELSS has the shortest lock-in period of only 3 years. All others have a minimum of 5 years of lock-in going up to 15 years.
  • ELSS has the potential of offering the highest returns on investment as it invests in stocks primarily. Most of the other tax saving options are government backed options which invest in fixed income instruments providing modest returns in comparison.

It goes without saying that since ELSS are market-linked there is an element of risk involved. You should choose your tax saving options based on your risk appetite. But you can start your SIP in ELSS with as low as 500 and reduce the risk factor.
Also, the main motivation for investing in ELSS should be wealth creation, tax savings should be treated as a bonus.

A word of caution: Choose your ELSS scheme carefully after proper research because if you pick a lemon you won’t be able to rectify your mistake for the next 3 years.

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