Saving Tax Through ELSS - Tax Benefits Of ELSS Funds

Last Updated: 16 Aug 2022

How are ELSS funds different from normal equity funds? Structurally both are equity funds with an equity portfolio mix. Hence, the only difference is the lock-in period in ELSS, which makes them eligible for tax breaks under Section 80C.

How does the lock-in period in ELSS schemes work?

Equity linked savings schemes (ELSS) are a variant of equity funds with a tax benefit embedded in it. That is the only difference, otherwise both are equity funds. Normally, equity funds do not have a lock-in period. That means, technically, you can sell the units as soon you get the allotment of units in 2-3 days. However, in case of ELSS, there is a mandatory 3 year lock in period.

What does that mean? It means that, you cannot redeem the ELSS investment before completing 3 years. This lock-in period if calculated from the date of investment. That means; if you do SIP on an ELSS fund, then each SIP instalment will be locked in for 3 years from the SIP date. So if you buy 3 SIPs on 10-Jan 2021, 10-Feb 2021 and 10-Mar 2021, then each of these instalments will get out of lock in period on 10-Jan 2024, 10-Feb 2024 and 10-Mar 2024 respectively.

Can you share with me some highlights of an ELSS scheme?

Why is it that ELSS is fast emerging as the preferred tax saving choice for investors?

• ELSS is a designated equity fund and the largest chunk of their portfolio has to be invested in equities. That makes them long term wealth creators.
• ELSS entails mandatory lock-in of 3 years and in case the units are redeemed then the tax benefits already claimed will have to be forfeited. This forces long term approach.
• ELSS is eligible for exemption under Section 80C of Income Tax Act up to outer limit of Rs.150,000. This enhances post tax effective returns on the ELSS fund.

Why are many young people finding elss as a good investment option?

It is clear that at least among the young and the upwardly mobile income earners, these tax saving schemes or ELSS funds have emerged as a default choice to begin with. They use this as a means to start to journey in tax planning as well as in exposure to equities. In the early stages, many first time investors are wary of investing in equities. ELSS can be an answer.

ELSS can be an answer to the uncertainties involved. The advantage with an ELSS fund is that it becomes a part of your regular tax saving routine. Also, the 3-year lock in period ensures that investors have to take necessarily a long term approach to equity investing which works in their favour. That explains why ELSS is becoming a great on-boarding instrument for first time investors and tax planners.

But, how does ELSS enhance effective returns over equity funds?

To understand the tax implication of the ELSS Funds, let us compare two investors viz. Investor A and Investor B. The former invests in an equity fund and the latter invests in an ELSS fund with exactly a similar portfolio. Here is how the comparative table looks like.

Investor A (Equity Fund)	Amount	Investor B ( ELSS Fund)	Amount
Investment amount	100,000	Investment amount	100,000
Value at the end of 3 years	175,000	Value at the end of 3 years	175,000
Profit in INR	75,000	Profit in INR	75,000
Total Returns over 3 years	75%	Total Returns over 3 years	75%
CAGR Returns	20.6%	CAGR Returns	20.6%
Effective Returns after considering Section 80C benefits
Exemption u/s 80C	–	Exemption u/s 80C	30,000
Effective Investment in T1	100,000	Effective Investment in T1	70,000
Effective CAGR Returns	20.6%	Effective CAGR Returns	35.8%
Note: For simplicity, we have ignored the impact of surcharge and cess on tax

How did 20.6% become 35.8%? How did such a big difference come about? How did the same fund with tax benefit give nearly double the returns? It is all about the tax exemption which reduces effective investment in Year 1 and that magnifies ROI. That is the power of an ELSS as the effective yields are after considering the tax shields at 30% tax bracket.

Is it true that ELSS fund managers take a longer term view?

There are really no empirical studies on that front, but intuitively you can say one thing. Tax shields and the higher effective returns are one side of the story. ELSS lock-in also gives the fund manager the luxury to avoid a short term approach to investing. Quite often, fund managers in equity funds tend to churn frequently due to pressure to book profits.

Most fund managers are required to hold cash to take care of redemption pressures. In ELSS funds, most investors are locked in for 3 years. Hence, the fund manager is assured of the longevity of the investor. This basically means that the fund manager can easily take a long-term view of investing which works in favour of the ELSS funds. However, if you leave out the tax benefit, no such unique benefit is evident in ELSS returns over equity fund returns.

How good an idea is doing SIP on an ELSS fund?

Just as you do systematic investment plans (SIP) on equity funds, you can do SIPs on ELSS funds too. In fact, it is a better idea too. The only difference is that each instalment of SIP is locked in for 3 years from the SIP date and this goes on progressively. There are certain distinct advantages in the SIP route to ELSS.

Firstly, a SIP approach helps you match outflows with inflows and impels you to start planning taxes early during the year than bunching at the end of the year. This ensures that taxes are planned in a systematic manner rather. Secondly, ELSS via SIP also gives you the benefit of rupee costing averaging (RCA), which is a distinct advantage in the midst of a volatile markets, as the SIP lowers your effective average cost of acquiring units.

How are dividends and capital gains taxed in ELSS schemes?

There is no difference between taxation of an equity fund and ELSS Fund with respect to taxation of dividends and capital gains.

• In the case of ELSS funds, any dividend is treated as other income and taxed at peak incremental rate. Now, there is no dividend distribution tax deducted by the fund.
• Short term capital gains tax is not applicable in case of ELSS Funds as it is locked in for a period of 3 years.
• All capital gains will be long term capital gains, which will be taxed at 10% flat over an exempt capital gain on equities to the tune of Rs.1 lakh. However, there will be no indexation benefit.