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What are pros and cons of investing in equity-linked savings schemes?

Of all types of investments deductible under Section 80C, ELSS tends to be one of the most popular and efficient tax-saving instruments. Here is all that you need to know about ELSS funds

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An Equity Linked Savings Scheme or ELSS is a type of equity diversified fund which invests a majority of its assets in equity shares of companies.
 
What is ELSS? A tax-saving investment deductible under Section 80C of the Income Tax Act
 
So, the next obvious question is: How does an ELSS fund work?
 
Well, the fund manager maintains a well-diversified portfolio by allocating resources across sectors, market capitalisation and industries. The Net Asset Value, 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 tends to get affected by the overall movement in the equity markets. The objective is to keep the portfolio returns in line with expectations, and not to let it be affected by extreme price movements in one of the industry segments. However, the fund attempts to generate enough returns which results in capital appreciation and tax benefits over the long term.
 
Now let's talk about the key features.
 
ELSS fund: Key features

  • Tax deduction of up to Rs 1,50,000 a year
  • Lock-in period of three years
  • No provisions of premature exit
 
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 or SIP in an ELSS fund today, it will not be available for redemption before 3 years from now. You may exit, redeem or reinvest your units of ELSS funds only after the expiry of the 3-year period. Just like any other equity fund, ELSS funds are available in both dividend and growth options.
 
ELSS fund: Tax implication
  • LTCG up to Rs 1 lakh is tax-free
  • LTCG over and above Rs 1 lakh is taxable at 10%
  • Investment up to Rs 1.5 lakh can be claimed as a deduction
 
From a tax standpoint, up to Rs 1 lakh of long-term capital gains (LTCG) from an ELSS scheme is tax-free. LTCG over and above Rs 1 lakh is taxable at the rate of 10%. Under Section 80C of the Income Tax Act, your investment up to Rs 1.5 lakh can be claimed as a deduction from your gross total income in a financial year.
 
Now, let's talk about the risk factors.
 
ELSS fund: Risk factors
  • Suitable for investors who have a relatively high risk-taking capacity
 
As ELSS predominantly invests in equities, in addition to other asset classes, these are suitable for investors with a relatively high risk-taking capacity. However, when compared with small/mid-cap funds, ELSS funds are safer because the volatility is much lower vis-a-vis the former. As these funds carry higher risk than debt funds, their return-generating potential is also higher than pure debt funds and balanced funds.
 
Now, here's how you can choose a top-performing ELSS.
 
How to choose a top-performing ELSS
  • Shortlist funds which have a relatively long fund history of, say, 5 years
  • Ensure that the fund’s returns are the result of the fund manager’s expertise
  • You may choose fund performance which matches your investment horizon
  • Ensure that the fund's philosophy is in line with your financial goals
  • Scrutinise the 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. 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.

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