ELSS: Smart way to save tax; here's how to pick a top performing one

Choose wisely but remember that returns are not guaranteed

Tax planning forms an indispensable part of one’s financial plans. Under Section 80C of the Income Tax Act 1961, you can claim deductions of upto Rs 1.5L and reduce your tax liability. So, to save on taxes, you just need to invest your money in investments eligible under 80C. Equity Linked Savings Scheme (ELSS) is eligible under section 80C.

Out of all these investments, ELSS tends to be the most popular and most efficient tax-saving instrument. 

How ELSS works

ELSS is a type of equity diversified fund, which invests majority of fund’s assets in equity shares of companies. The fund manager maintains a well-diversified portfolio by allocating resources across sectors, market capitalisation and industries. The Net Asset Value (NAV), or the intrinsic value of one unit of the fund, fluctuates with ups and downs of the underlying benchmark and overall economic factors. 

The investment mechanism of ELSS is such that fund return tend to get affected by the overall movements of the equity markets. The objective is to keep the portfolio returns in line with expectations and not get it affected by extreme price movements in one of the industry’s segments. However, the fund attempts to generate enough returns which results in capital appreciation and tax benefits over the long-term. 

Lock-in period and redemption

Unlike other funds, ELSS comes with a lock-in period of 3 years from the date of investment. It means that if you initiate a Systematic Investment Plan (SIP) in an ELSS fund today, then it will not be available for redemption before completion of 3 years from the respective date of investment. Nevertheless, you may exit, redeem or reinvest your units of ELSS funds after expiry of 3 years. Just like any other equity fund, ELSS funds is available in both dividend and growth options.

In growth option, when you redeem your investment after 3 years, you get your investment back along with capital appreciation, if any, in a lump sum. Conversely, in a dividend option, you receive a regular dividend income from the fund house even during the lock-in period. But there are no guaranteed dividends unless the fund generates a profit. It is not permitted to declare dividends out of the capital. 

Tax implications

From a tax standpoint, long-term capital gains (LTCG) from an ELSS scheme upto Rs 1 Lakh are tax free. LTCG over and above Rs 100,000 are taxable at the rate of 10%. Under Sec 80C of the Income Tax Act, your investment upto Rs. 150,000 can be claimed as a deduction from your gross total income in a financial year.

In general, you can enjoy tax savings in 3 ways by investing in mutual funds namely tax deductions, tax exemptions and benefit of indexation. ELSS funds helps you to claim a tax deduction of upto Rs 150,000 by deducting the amount of investment from the taxable income and reducing your tax liability. Under tax exemption, the long-term capital gains (LTCG) upto Rs 1 lakh made from sale of equity shares or mutual funds is tax free. 

Risk factors and return potential

As ELSS predominantly invest in equities, in addition to other asset classes, these are suitable for investors who have a relatively higher risk-taking capacity. However, as compared to small/mid-cap funds, ELSS funds are relatively safer bets because the volatility is much lower vis-a-vis the former. As these funds carry higher risk than debt funds, the returns generating potential is also higher than pure debt funds and balanced funds. 

ELSS funds can be an ideal way to generate wealth in the long run to achieve financial goals like retirement planning. You only need to understand that proper selection of funds is the main requisite for this to happen. You may do a thorough research before investing in an ELSS fund of your choice. You may use some quantitative and qualitative factors to arrive at appropriate funds for your portfolio. 

How to choose a top-performing ELSS

Start with analysing the fund history. Shortlist funds which have a relatively longer fund history of say at least 5 years. Ensure that fund returns are the result of fund manager’s expertise and not by a matter of chance. You may choose fund performance which matches with your investment horizon. Examine the fund’s overall investment philosophy and ensure that it is in line with your financial goal. Additionally, you may scrutinise fund’s expense ratio and check whether it justifies the fund’s alpha. However, at the end of the day, you need to remember that fund returns are not guaranteed.

Conclusion

ELSS funds are a smart way to save a lot on your tax outgo. But you need to bear in mind that the returns are not guaranteed. Consult your financial advisor before investing. 

Archit Gupta is founder and CEO of ClearTax