Equity-Linked Savings Schemes (ELSS) are a popular investment option in India, offering both tax savings and the potential for long-term capital growth. ELSS funds are a type of diversified equity mutual fund that invests predominantly in equity and equity-related instruments. One of the key advantages of ELSS is that they provide tax benefits under Section 80C of the Income Tax Act, making them an attractive option for those looking to reduce their taxable income while also investing for future financial goals.

How to Use ELSS (Equity-Linked Savings Schemes) to Save Tax

This comprehensive guide will explain how to use ELSS to save tax, the benefits of ELSS, and provide answers to frequently asked questions (FAQs) regarding these funds.

What is ELSS?

Equity-Linked Savings Schemes (ELSS) are mutual funds that invest primarily in equities and equity-related securities. ELSS funds come with a lock-in period of three years, which is the shortest lock-in period among all tax-saving investment options under Section 80C. The primary purpose of ELSS is to provide investors with tax benefits while also giving them the potential to earn higher returns through equity market exposure.

ELSS funds have two key components:

  1. Equity Investment: ELSS primarily invests in stocks, meaning the returns are linked to the performance of the equity market.
  2. Tax Benefit: Investments in ELSS qualify for tax deductions under Section 80C, up to a maximum of ₹1.5 lakh per financial year.

Why Use ELSS to Save Tax?

  1. Tax Savings Under Section 80C: The most significant advantage of ELSS is the tax deduction it offers. You can claim a deduction of up to ₹1.5 lakh under Section 80C, which reduces your taxable income and consequently lowers your tax liability. If you are in the highest tax bracket (30%), investing ₹1.5 lakh in ELSS can save you up to ₹46,800 in taxes.
  2. Short Lock-in Period: ELSS funds come with a mandatory lock-in period of three years, which is shorter than other tax-saving options such as Public Provident Fund (PPF), National Savings Certificate (NSC), or fixed deposits, which often have lock-in periods of five years or more. After the three-year lock-in period, you are free to redeem your investment or keep it invested for longer.
  3. Potential for High Returns: Since ELSS invests predominantly in equities, they have the potential to generate higher returns compared to other tax-saving instruments like fixed deposits or PPF. While equity markets are volatile in the short term, they tend to offer better returns in the long term, making ELSS a suitable option for wealth creation.
  4. Power of Compounding: By investing in ELSS through a Systematic Investment Plan (SIP), you can benefit from the power of compounding over time. Regular, disciplined investments in ELSS not only help you save tax but also accumulate wealth as your investments grow and generate returns.
  5. Diversified Portfolio: ELSS funds invest in a broad portfolio of stocks across various sectors and industries, providing diversification and helping to reduce risk. While equity investments are subject to market fluctuations, diversification within the fund helps mitigate the impact of underperformance in any one sector or stock.
  6. Flexibility: Unlike some tax-saving investments that lock your money in for extended periods, ELSS gives you the flexibility to redeem your investments after the three-year lock-in period. You can continue to hold the investment for the long term if you prefer, allowing it to grow without any pressure to withdraw.

How to Invest in ELSS for Tax Savings

Choose the Right ELSS Fund

    • Selecting the right ELSS fund is crucial for maximizing your returns and achieving your financial goals. Different ELSS funds have different investment strategies and risk profiles, so it’s important to choose one that aligns with your risk tolerance and investment horizon.
    • Compare the historical performance of various ELSS funds, looking at their 3-year, 5-year, and longer-term returns. While past performance is not a guarantee of future returns, it can provide insights into how the fund has fared across market cycles.
    • Assess the fund's expense ratio, which is the fee charged by the mutual fund company for managing the fund. Lower expense ratios are preferable because they leave more of your returns intact.

Decide Between Lump Sum or SIP

    • You can invest in ELSS through a lump sum investment or a Systematic Investment Plan (SIP). A lump sum investment is a one-time investment, while an SIP allows you to invest a fixed amount at regular intervals (monthly or quarterly).
    • SIPs are ideal for those who want to invest regularly and systematically over time, as they help reduce the impact of market volatility through rupee cost averaging. Investing via SIP also instills financial discipline and makes it easier to invest consistently without the need for large sums of money upfront.
    • If you have a large amount to invest before the financial year ends to maximize your Section 80C deduction, a lump sum investment may be appropriate.

Monitor and Review Your Investment

    • While ELSS has a lock-in period of three years, it is important to monitor the performance of your investment regularly. After the lock-in period, you can choose to stay invested in the fund for the long term if it is performing well or switch to another ELSS fund if necessary.
    • Remember that equity investments are volatile in the short term, so don’t panic if you see temporary fluctuations in the value of your ELSS investment. Keep your long-term goals in mind and stay invested for at least five to seven years to maximize returns.

Plan for Tax Efficiency

    • Keep in mind that ELSS investments are subject to capital gains tax. Long-term capital gains (LTCG) from equity investments exceeding ₹1 lakh in a financial year are taxed at 10%. To optimize your tax savings, consider spreading your ELSS redemptions over multiple financial years to stay within the ₹1 lakh exemption limit.

How to Use ELSS (Equity-Linked Savings Schemes) to Save TaxFAQs About ELSS

1. What is ELSS, and how does it help in saving taxes?

ELSS is an Equity-Linked Savings Scheme, a type of mutual fund that invests primarily in equities and equity-related instruments. It helps in saving taxes because investments in ELSS are eligible for deductions under Section 80C of the Income Tax Act, up to a limit of ₹1.5 lakh per financial year. This reduces your taxable income and helps lower your overall tax liability.

2. What is the lock-in period for ELSS?

ELSS funds come with a mandatory lock-in period of three years. This means that once you invest in an ELSS fund, you cannot redeem or withdraw your investment for three years from the date of purchase. After the lock-in period, you are free to redeem your investment or continue holding it for longer.

3. Can I withdraw my ELSS investment before the lock-in period?

No, ELSS investments are locked in for three years, and you cannot withdraw your investment during this period. After the three-year lock-in period, you can redeem your investment at any time without any penalties.

4. What are the tax benefits of ELSS?

Investments in ELSS qualify for tax deductions under Section 80C of the Income Tax Act, up to a maximum of ₹1.5 lakh per financial year. By investing in ELSS, you can reduce your taxable income and lower your overall tax liability. However, the returns from ELSS are subject to long-term capital gains (LTCG) tax.

5. How are returns from ELSS taxed?

Returns from ELSS are subject to long-term capital gains (LTCG) tax. LTCG on equity investments, including ELSS, exceeding ₹1 lakh in a financial year are taxed at 10%. Gains up to ₹1 lakh in a financial year are exempt from LTCG tax.

6. Should I invest in ELSS through a lump sum or SIP?

You can invest in ELSS through either a lump sum or SIP, depending on your financial situation and investment strategy. A lump sum investment involves investing a large amount at once, while an SIP allows you to invest smaller amounts at regular intervals (monthly or quarterly). SIPs are a popular choice because they help reduce the impact of market volatility and instill financial discipline.

7. What are the risks associated with ELSS?

Since ELSS funds invest primarily in equities, they are subject to market risks and can experience volatility, especially in the short term. The value of your investment may fluctuate depending on stock market performance. However, equities tend to outperform other asset classes over the long term, so ELSS can be a good option for long-term wealth creation.

8. What should I consider when choosing an ELSS fund?

When choosing an ELSS fund, consider factors such as:

  • The fund’s past performance over 3-year, 5-year, and longer-term periods.
  • The expense ratio, as lower costs can enhance your returns.
  • The fund manager’s track record and investment strategy.
  • The fund’s portfolio diversification across sectors and industries. Choose a fund that aligns with your risk tolerance and long-term financial goals.

9. Can I continue to hold my ELSS investment after the lock-in period?

Yes, after the three-year lock-in period, you can continue to hold your ELSS investment for as long as you like. In fact, it is often advisable to stay invested in ELSS for the long term to maximize returns and benefit from the power of compounding. There is no obligation to redeem your investment once the lock-in period is over.

10. How many ELSS funds can I invest in under Section 80C?

There is no limit to the number of ELSS funds you can invest in. However, the total amount eligible for deduction under Section 80C is capped at ₹1.5 lakh per financial year. You can invest in multiple ELSS funds if you wish, but the tax benefit will be limited to ₹1.5 lakh in a given year.

11. Can NRIs invest in ELSS?

Yes, Non-Resident Indians (NRIs) can invest in ELSS funds, provided they adhere to the regulations set by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). NRIs can claim tax benefits under Section 80C of the Income Tax Act on their investments in ELSS.

12. What happens if I redeem my ELSS investment after the lock-in period?

Once the lock-in period of three years is over, you are free to redeem your ELSS investment. The returns will be subject to long-term capital gains (LTCG) tax if your gains exceed ₹1 lakh in a financial year. You can also choose to continue holding your investment to allow it to grow further, depending on your financial goals and market conditions.

Conclusion

Equity-Linked Savings Schemes (ELSS) offer a powerful combination of tax savings and potential for long-term capital appreciation, making them an ideal investment option for individuals looking to save taxes and build wealth over time. With the shortest lock-in period among tax-saving investments, flexibility, and the opportunity to earn higher returns through equity exposure, ELSS stands out as a compelling choice under Section 80C.

By selecting the right ELSS fund, investing regularly through SIPs, and staying invested for the long term, you can maximize the benefits of ELSS for both tax savings and wealth creation. While ELSS comes with risks due to its equity exposure, its long-term growth potential makes it a suitable option for individuals with a longer investment horizon and a moderate to high risk tolerance.

Whether you’re a first-time investor or looking to enhance your tax-saving strategy, ELSS can help you achieve your financial goals while reducing your tax burden.