ELSS Mutual Funds - Tax Saving Mutual Fund Investment

What is an ELSS (Tax Saving Mutual Fund)?

An Equity Linked Savings Scheme (ELSS) is a type of mutual fund that mostly invests in equities and offers tax benefits under Section 80C of the Income Tax Act. It has a mandatory 3-year lock-in period, the shortest among tax-saving mutual funds, and provides the potential for higher long-term returns. ELSS combines wealth creation with tax savings, making it popular among long-term investors.

Features of ELSS mutual funds

• Equity-oriented: ELSS mutual funds invest primarily in equity and equity-related instruments, offering potential for higher long-term returns.

• Short lock-in period: These funds have a mandatory 3-year lock-in, the shortest among Section 80C options like PPF or NSC.

• Tax-saving benefit: ELSS funds are eligible for deductions under Section 80C of the Income Tax Act, up to Rs. 1.5 lakhs annually.

• Flexibility in investment mode: Your money can be invested as a lump sum or through a Systematic Investment Plan (SIP).

• Growth and dividend options: Investors can choose between reinvesting profits or receiving periodic payouts.

• No premature redemption: Funds are locked for 3 years, ensuring disciplined investing.

• Dual advantage: ELSS funds combine tax savings with wealth creation through market-linked growth.

• Professional fund management: These tax-saving funds are managed by experienced fund managers with diversified portfolios across sectors and market caps.

• Potential for higher risk: The returns are market-linked, making them suitable for moderate to high-risk investors.

Taxation on ELSS Mutual Funds

• Tax benefits on investment: Investments in ELSS qualify for deductions under Section 80C, up to Rs. 1.5 lakhs per financial year.

• Lock-in period: A 3-year mandatory lock-in applies to ELSS funds. Taxation is calculated when you redeem them after this period.

• Long-Term Capital Gains (LTCG) tax: Since ELSS units are held for more than one year, gains are taxed as LTCG. Gains up to Rs. 1 lakh in a financial year are tax-free. However, when amounts exceed Rs. 1 lakh, they are taxed at 10% without indexation.

Who Should Invest in Tax Saving Funds?

Tax-saving mutual funds, especially Equity Linked Savings Schemes (ELSS), are ideal for investors looking to combine tax benefits with the potential for wealth creation. They suit:
 

• Salaried individuals and professionals: Anyone seeking deductions under Section 80C (up to ₹1.5 lakh per year) while aiming for market-linked returns.

• Long-term wealth builders: Investors willing to stay invested beyond the 3-year lock-in to maximize the benefits of compounding and ride out market volatility.

• First-time equity investors: ELSS can be a good entry point for those new to equities, offering diversification and professional fund management.

• Young investors: With a longer investment horizon and higher risk tolerance, young earners can benefit most from the growth potential of equities.

• Goal-based investors: Those saving for future milestones like retirement, children’s education, or a house down payment can align ELSS with long-term goals.

• Moderate to high-risk takers: Since ELSS invests in equities, it is better suited for those comfortable with short-term fluctuations while seeking higher returns.
   

ELSS is not ideal for ultra-conservative investors or those needing short-term liquidity, but it can be a valuable addition to a tax-saving and wealth-building strategy.

What are the Risks Associated with ELSS Funds?

Equity Linked Savings Schemes (ELSS) are popular for their tax benefits under Section 80C and potential for high returns. However, as equity-focused investments, they carry certain risks that you must understand before allocating your money for the 3-year lock-in period.
 

• Risk of total loss: While complete loss is rare for diversified ELSS funds, there is always a possibility of significant capital loss if there are prolonged downturns in the market. Poor stock selection or extreme market crashes could lead to large losses over time.

• Price risk: ELSS funds are equity-oriented, so their value fluctuates with stock market movements. Sudden market volatility, sector downturns, or company-specific issues can cause short-term declines in Net Asset Value (NAV). Overconcentration in certain sectors can increase price fluctuations.

• Liquidity risk :ELSS has a mandatory 3-year lock-in period, which means you cannot exit early even during unfavorable market conditions. This limits your ability to quickly access funds in emergencies or switch to better opportunities.

• Event risk: Returns can be affected by factors like inflation, interest rate changes, or currency fluctuations. Global crises, geopolitical tensions, and changes in government policy or taxation can also negatively impact the equity markets and, consequently, ELSS performance.

Key Considerations Before Investing in ELSS

Before investing in tax-saving mutual funds, you must consider the following:
 

1. 1. Past performance: Evaluate the fund’s 5-10-year track record, focusing on consistent returns across market cycles rather than short-term gains.

2. 2. Risk tolerance: ELSS invests primarily in equities, making them market-linked. Choose funds aligning with your risk profile.

3. 3. Expense ratio: Lower expense ratios mean more of your money is working for you, which can increase long-term returns.

4. 4. Portfolio composition: Review sector allocation, market cap exposure, and diversification to ensure balanced risk.

5. 5. Fund manager expertise: A skilled and experienced fund manager can significantly influence returns.

6. 6. Growth or dividend: The growth option is generally better for wealth creation, while dividends can provide periodic payouts.

How to choose the best tax-saving mutual fund?

Many factors, like financial goals, investment horizon, and risk appetite, impact your choice of a tax-saving mutual fund. You must evaluate each of these factors before investing.
 

1. 1. Investment purpose: Each ELSS fund comes with an investment strategy. Make sure you understand this strategy to ensure that it aligns with your investment objective.

2. 2. Match with financial goals: You may have long-term investment goals like wealth building, children’s education, or retirement. Determine your goals to identify the best tax-saving mutual fund for you. 

3. 3. Balance between risk and reward: Generally, the risk associated with tax-saving funds is higher. It is proportionate to the higher returns. Make sure you evaluate the risks associated with the mutual funds to ensure they meet your risk appetite and don’t cause financial troubles. 

4. 4. Lock-in period and liquidity: ELSS has a 3-year lock-in, the shortest among other Section 80C investments. Ensure you are comfortable with this commitment. Moreover, tax-saving mutual funds don’t give returns over a short period. So, if you have shorter liquidity requirements, you must choose debt funds instead.

Methods to Invest in ELSS Mutual Funds

The different methods to invest in ELSS mutual funds are as follows:
 

1. 1. Growth option
    

   • You receive market-linked returns, which means the fund’s growth is based on the performance of the underlying equity securities. 

   • There are no regular income payouts. 

   • The investment’s value can increase with time, promising higher returns when redeemed. 
      

2. 2. Dividend option
    

   • You get regular income payouts. 

   • Taxes on dividends are calculated based on the investor’s tax slab. 

   • If dividends exceed Rs. 5,000, a Tax Deducted at Source (TDS) is applied at 10%.
      

3. 3. Dividend reinvestment option
    

   • Dividend payouts are reinvested into the ELSS fund automatically. 

   • Reinvestment gives a higher Net Asset Value (NAV) in the long run. 

   • Reinvestment can leverage market gains during positive market conditions. 

List of the best ELSS (tax-saving) mutual funds

Here’s a table highlighting the 10 best tax-saving mutual funds in India:

How Do Tax Saving Mutual Funds Work?

Tax-saving mutual funds, or ELSS, are similar to diversified multi-cap equity funds. However, unlike multi-cap equity funds, tax-saving mutual funds have a mandatory 3-year lock-in period. 
 

1. Investment strategy : Tax-saving mutual funds, primarily Equity Linked Savings Schemes (ELSS), invest mostly in equities and equity-related instruments. Typically, over 80% of the portfolio is allocated to stocks across sectors and market capitalizations to balance growth potential with risk. Investors can choose to invest through a lump sum or a Systematic Investment Plan (SIP) for disciplined investing.

2. Fund management: ELSS mutual funds are managed by professional fund managers who select and monitor stocks using market research, company analysis, and economic trends. Diversification across sectors helps reduce risk, and the lock-in allows managers to focus on long-term strategies without frequent redemption requests.

3. Tax benefits: Investments in ELSS qualify for deductions up to Rs. 1.5 lakhs per year under Section 80C. Gains after the lock-in are taxed as Long-Term Capital Gains (LTCG), with the first Rs. 1 lakh per year tax-free and the excess taxed at 10% without indexation. Dividends, if opted for, are taxed as per the investor’s slab rate.

4. Lock-in period: ELSS funds have a mandatory 3-year lock-in, the shortest among Section 80C instruments. This ensures disciplined investing and allows the fund to benefit from market cycles, but it also means you cannot redeem your investment early, even in emergencies.

Investing in tax-saving mutual funds is simple and straightforward. You can invest directly through a fund house or via online platforms such as Tata Capital Moneyfy to research and invest in funds of your choice.