ELSS Funds or Equity Linked Savings Schemes are commonly known by the term “tax saving funds” due to their unique characteristic of providing tax saving options with market-linked returns. ELSS has recently become one of the most popular tax saving investments available in India. It tends to appeal largely to young investors who aim to increase their savings while enjoying tax savings.
If you are planning to invest in ELSS funds, these are a few key factors that you must know before getting into it.
1. Understanding Asset Composition of ELSS Funds
ELSS funds are equity-oriented schemes, which means the fund manager invests at least 80% of the fund’s money in stocks and equity-related instruments. The remaining portion (up to 20%) can be invested in fixed-income securities or money market instruments for stability.
Fund managers have the flexibility to choose which types of stocks to invest in based on the fund’s objective and risk level. For example:
- A high-risk ELSS fund might invest more heavily in small-cap and mid-cap stocks for higher growth potential.
- A moderate-risk ELSS fund might focus more on large-cap stocks for stability and steady returns.
This means not all ELSS funds are the same. You should choose one that matches your risk appetite and investment goals.
2. Lock-in Period: Shortest Among Tax-Saving Options
One of the biggest advantages of ELSS funds is their short lock-in period. Under Section 80C of the Income Tax Act, most tax-saving investments come with mandatory lock-in periods. Here’s how ELSS compares:
- ELSS Funds: 3 years (shortest lock-in)
- Public Provident Fund (PPF): 15 years
- National Savings Certificate (NSC): 5 years
- Tax-Saving Fixed Deposits: 5 years
The 3-year lock-in period of ELSS is the lowest among all tax-saving options under Section 80C. This makes ELSS attractive for investors who want tax benefits without locking their money away for too long. The lock-in period also encourages long-term investing, which helps you benefit from compounding and ride out market volatility.
Important Note: You cannot redeem or withdraw your ELSS units before the completion of 3 years from the date of investment.
3. Invest in ELSS Through SIP for Better Results
A Systematic Investment Plan (SIP) is a smart way to invest in ELSS funds. Instead of investing a lump sum amount at once, you invest a fixed amount regularly—usually monthly. This approach offers several benefits:
Rupee Cost Averaging
When you invest through SIP, you buy more units when prices are low and fewer units when prices are high. Over time, this averaging reduces your overall cost per unit and helps you navigate market ups and downs without worrying about timing the market.
Disciplined Investing
SIP builds financial discipline. A small amount is automatically deducted from your bank account every month, helping you invest consistently without thinking about it.
Lock-in Applies Per Installment
In ELSS SIP, the 3-year lock-in period applies to each individual installment. Here’s an example to make it clear:
- January 1, 2021: ₹5,000 invested → Lock-in until January 1, 2024
- February 1, 2021: ₹5,000 invested → Lock-in until February 1, 2024
- March 1, 2021: ₹5,000 invested → Lock-in until March 1, 2024
So if you start a monthly SIP, your first installment becomes available for withdrawal after 3 years, followed by the second installment a month later, and so on.
4. Avoid Adding Too Many ELSS Funds to Your Portfolio
When it comes to tax-saving, many investors make the mistake of buying a new ELSS fund every year without proper planning. They focus only on saving tax and ignore the bigger picture of portfolio management.
Over a few years, this leads to owning multiple ELSS schemes, often from different fund houses, which can create:
- Over-diversification: Too many funds can dilute your returns.
- Overlap: You might end up with multiple funds investing in similar stocks, defeating the purpose of diversification.
- Tracking difficulty: Managing and reviewing too many funds becomes complicated.
Best Practice: Stick to 1-2 well-performing ELSS funds that align with your risk profile and financial goals. Review them annually and make changes only if needed. Quality matters more than quantity.
5. Understanding the Risk Level
Since ELSS funds invest primarily in equities, they carry market risk similar to investing directly in stocks. However, this doesn’t mean all ELSS funds are equally risky.
ELSS funds come in different risk categories:
- High Risk: Focus on small-cap and mid-cap stocks with higher growth potential but more volatility.
- Moderate Risk: Balanced approach with a mix of large-cap and mid-cap stocks.
- Moderate to Low Risk: Focus on large-cap stocks for stability and steady returns.
Important: Higher risk usually comes with higher potential returns. But it also means more ups and downs in your investment value. Choose an ELSS fund that matches your risk tolerance and investment horizon.
If you’re a conservative investor, opt for ELSS funds that invest primarily in large-cap stocks. If you’re comfortable with volatility and have a longer time horizon, you can consider ELSS funds with higher exposure to mid-cap and small-cap stocks.
Additional Things to Keep in Mind
- Tax Benefits
ELSS funds offer tax deduction under Section 80C up to ₹1.5 lakh per financial year. This can significantly reduce your taxable income. Additionally, long-term capital gains (after 3 years) are taxed at 10% only on gains exceeding ₹1 lakh per year.
- Returns
ELSS funds have the potential to deliver higher returns compared to traditional tax-saving instruments like PPF or NSC. Historically, good ELSS funds have delivered returns in the range of 12-15% annually over the long term, though past performance doesn’t guarantee future results.
- Exit Strategy
Since each SIP installment has its own 3-year lock-in, plan your exit strategy accordingly. You can set up a Systematic Withdrawal Plan (SWP) after the lock-in period to receive regular monthly income, or redeem the units as per your financial needs.
Conclusion
ELSS Funds can prove to be a very good investment option for those who want to save taxes and create wealth through equity investments simultaneously. These instruments provide the shortest tenure of lock-in for all tax saving instruments, good returns, and flexibility of SIP investing.
However, before investing, make sure you:
- Understand the asset composition and risk level of the fund.
- Invest through SIP to benefit from rupee cost averaging.
- Avoid accumulating too many ELSS funds in your portfolio.
- Choose funds that align with your financial goals and risk appetite.
By doing your research and planning your ELSS investments carefully, you can maximize your tax savings while building a strong investment portfolio for the future.
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