Individuals who have taken an interest towards creating an investment portfolio would almost certainly hear these two words: mutual funds. This often used term is a near constant when it comes to investing in the financial markets. Be it equity or fixed income, or a novice or an experienced investor, mutual funds are always present in a discussion about growing wealth.

But it would be an error to assume that the only function that mutual fund perform is that of earning returns for a portfolio. A specific type of fund can also help investors save on taxes. One of these funds are Equity Linked Saving Schemes (ELSS).

In terms of structure, portfolio make-up, and functioning, an ELSS is exactly like an equity-oriented mutual fund scheme. However, unlike a typical diversified or multi-cap fund, it provides tax benefits under section 80C of the Income Tax Act. Because of this attribute, an ELSS can not only help in generating returns by trying to outperform the market, but it can also provide the additional benefit of tax savings.

Tax saving features of ELSS Funds:

Though individuals are attracted towards ELSS because of the tax benefits that they offer, they can get an add-on benefit of gaining from favourable market movement as well. This combination is what makes ELSS stand out among instruments which help save tax.

1. Section 80C of the Income Tax Act allows an individual a total amount of Rs 1.5 lakhs as tax deductible. An investor can invest this entire amount into ELSS funds. There is no cap on the amount an investor can invest in these funds. If this limit is breached, however, an investor will not be able to claim tax deduction on the amount exceeding this limit. The amount of taxes one can save using ELSS funds depends upon the tax bracket one belongs to.

Alike other tax savings instruments, there is a lock-in period of investment in ELSS funds as well. This period spans three years from the date of investment. Therefore, an investment made on July 1, 2019 can only be redeemed on July 1, 2022. This is a feature that differentiates a best ELSS mutual fund from traditional mutual funds as the latter do not have a lock-in period of investment.

2. Working out the lock-in period in case of SIPs

At this juncture, some interested investors might want to know how the lock-in period works in case they have chosen the SIP (Systematic Investment Plan) route to invest in these funds. For example, an investor may have decided to invest Rs 1,20,000 spread over 1 year in an ELSS fund. This investment begins on July 1, 2019. In this case, the entire amount will not be available for redemption on July 1, 2022.

For understanding how this functions, an investor will need to determine the number of units that he holds. Taking into consideration the aforementioned example, the SIP amount works out to be Rs 10,000 per month. By dividing the net investment amount by the Net Asset Value (NAV) on the date of transaction will provide an investor with the number of units that were purchased on that day. Given that these units were purchased on July 1, 2019, only these number of units will be available for redemption on July 1, 2022.

Similarly, the number of units bought in the remaining 11 months will become available for redemption in the same manner. Thus, the next set of units will be available for redemption on August 1, 2022, followed by the next set on September 1, 2022, and so on.

One can also choose to redeem the entire amount at one go even when choosing the SIP route. In order to do this, this investor would need to wait for the end of three years after the final SIP amount. In the aforementioned example, that date would be June 1, 2023 or after.

What investors stand to gain by investing in ELSS mutual funds

1. It is undeniable that among investment choices for the purposes of saving tax, ELSS funds are quite possibly the riskiest bet. This is because they invest in stocks and when it comes to investing in equities, there are no guaranteed returns. However, one should not look at ELSS for purely tax saving purpose. Investors should think about them as an extension of their mutual fund portfolio which also helps them save taxes. Not only this, investing in ELSS opens up the possibility of earning superior returns as compared to other tax saving instruments like fixed deposits and government small savings schemes.

2. Further, ELSS funds are a great way to test one’s comfort of investing in equity markets. Because of a three year lock-in period, investment discipline is automatically instilled into investors. This provides them the opportunity to actually see how long-term investing works and can get them interested in other mutual funds and equity market products.

3. Another major benefit of ELSS funds is that they have the shortest lock-in period among all instruments that can help investors save tax. Tax saving fixed deposits and National Savings Certificates (NSCs) have a lock-in period of five years, Public Provident Fund (PPF) has a maturity of 15 years with partial withdrawal allowed only from the seventh year. On the other hand, as stated earlier, ELSS funds have a lock-in of just three years.

Given the nature of the investment, while PPF and fixed deposits can provide returns in high single digits, the returns on ELSS funds can be in double digits; in good market conditions, they can go 2 to 3 times higher than returns on the aforementioned instruments.

Investment strategy given the performance of ELSS fund

Let’s address the method investors can adopt based on whether their ELSS fund is performing well or faring poorly at the end of the three year lock-in.

1. After the lock-in period expires, an ELSS fund becomes open-ended. An investor can redeem his entire investment at one go or can do so in parts. If the fund has displayed strong performance during the period, investors can continue to remain invested; the tax benefits will cease after three years, but efficient fund management would not. In such a scenario, investors should look at ELSS funds as a wealth generation mechanism and not just as a tool to save taxes. The lock-in enforces discipline and also allows the fund management team to deploy fund efficiently and with conviction, both of which can result into good returns.

2. On the other hand, if the ELSS fund has performed poorly, investors can undertake one of two options. Firstly, if the poor performance has resulted due to a bear market, investors can continue to remain invested in order to allow their depleted capital to grow and increase in value. However, if the fund has fared badly even after the broad market doing well, he can make use of the Systematic Transfer Plan (STP) and switch to another fund.

It is not uncommon for ELSS funds to outperform diversified or multi-cap mutual funds in terms of returns. An investment journey with a well-managed ELSS fund will not only help investors save on taxes but also increase chances of wealth generation.

Author's Bio: 

Hi, I am Amit Gupta. I am owner of amazingviralnews.com