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What is ELSS and what does it do?

ELSS refers to Equity Linked Savings Scheme, a close-ended investment instruments with a lock-in period of 3 years. It is essentially a mutual fund instrument that is based on the performance in the equity markets offered by Mutual Funds Companies in India. An ELSS mutual fund invests at least 80% of its total assets in equity and equity-related instruments. ELSS can be invested using both SIP (Systematic Investment Plan) and lump-sum investment options.

A reason why Seema actively recommends it to all the employees in her company when they run helter-skelter to find tax saving schemes towards the end of March every year. As a HR professional working in a corporate office, Seema looks after the employee payroll and financial health programmes in close association with the company’s accounts department.

Seema will however warn you that anything linked to equity markets always has some rub off of how the markets are doing. If the stock markets take a dip, so will your ELSS savings. A good thing then, that there is a lock-in period that gives a fair chance for your investments to grow steadily.

 

Why is ELSS an important investment?

Seema understands the importance of tax compliances and is well versed in the various instruments that help save on taxes such as insurance policies, government bonds, ELSS etc. She conducts seminars in the office every now and then to educate the other employees too. But for Seema, the learning is very clear. Savings cannot be made simply to save taxes or keep your hard earned money safe. It should also work for you to make more money. She also believes end of March shouldn’t be the only time one must get busy investing. Because, there is no one single occasion for your money to grow. It will grow all year round, if you know how to plan for it.

 

What are the tax benefits of investing in ELSS?

An ELSS comes with a statutory lock-in period of 3 years and qualifies for a tax exemption under section 80C of the Income Tax Act of the Government of India.

It allows a maximum tax exemption of Rs. 1,50,000 per investor. Which essentially means, any investment above Rs. 1,50,000 becomes taxable.  The advantage however is that the 3-year lock-in period is ideal in terms of liquidity as compared to other options like NSC and Public Provident Fund that lose a huge chunk of benefits if withdrawn before the really long maturity dates.

Here’s a quick comparison between ELSS and other tax-saving methods sanctioned by the Government of India

InvestmentReturnsLock-in periodTax on Returns
5-Year Bank Fixed Deposit6 to 7%5 yearsYes
Public Provident Fund (PPF)7 to 8%15 yearsNo
National Savings Certificate (NSC)7 to 8%5 yearsYes
National Pension System (NPS)8 to 10%Till retirementPartially Taxable
ELSS Funds15 to 18%3 yearsPartially Taxable

 

Capital gains clause

Sounds great so far, doesn’t it? An investment option that allows you to safely play the equity markets, save as well as earn money and save taxes at the same time! Seema will put in a word of caution here.

The returns on ELSS funds are subject to a long term capital gains tax (LTCG) at 10.4%. Which means, your ELSS investment value will continue to grow along with how the stock market performs. But the day you decide to liquidate it, you will need to pay tax on it, given the nature of the instrument. So, when you plan your investments, you need to be sure about what you are seeking from it and invest accordingly.

However long term capital gains up to Rs. 1 lakh per year are exempt from tax.

The capital gains tax is also applicable if you redeem (cash) the units after holding for 12 months then the profit.

However, the dividend income is tax free too irrespective of the holding period.

Lock-in period

Is the 3-year lock in period that goes hand in hand with investing in a ELSS very long or very short? This is one question Seema gets asked often when she explains the ELSS. For her personally, it is an ideal time frame to plan for corpus build up to fund her various activities. While the first three years may be a bit of a tight spot, with you having to figure out other sources of funding your annual expenses like vacations, school fees for the kids, etc., Seema has been investing in ELSS for many years now, year after year. She even has the SIP option liked to her monthly salary. She has outlined her investment distribution as well as the cycle in a manner that she’s invested across the year, over many such schemes.

This allows her to be very flexible with the liquidity needs. On one hand she doesn’t have to liquidate all her investments at once. On the other, the ELSS that she invested in 3 years ago, does provide her with the easy access to the funds when needed.

The above scenario only works if one is planning lump sum annual investments, especially if you are seeking annual liquidity plan. Remember, the lock-in also applies to your systematic investment plans (SIP); every monthly installment you make in an ELSS is subject to a 3-year lock-in.

She advises everyone in her office to plan accordingly.

ELSS versus other mutual funds

ELSS -Equity Linked Savings Scheme- is just like any other Mutual Fund with the main differentiator being that you cannot withdraw money before 3 years due to the mandatory lock-in period. In other equity funds there is no lock-in, though there is an exit load.

So fund managers need to be actively making sure they have a liquid enough portfolio to meet redemption pressures if any.

How is this different in ELSS? First and foremost, since each cash flow has a lock-in of 3 years, your fund manager can take long term calls on stocks and on the overall portfolio. It also means that the fund manager does not worry about meeting redemption pressures in the short run. This results in the churn ratios (also called turnover ratio) being lower in ELSS. This is one of the main reasons that returns are a bit higher.

Furthermore, your fund manager then can choose value stocks or growth stocks depending on the given mandate of the fund.

Seema recommends you speak to your bank officer about identifying the best ELSS for you.

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