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Best ELSS Funds

Scheme Name AUM(Cr.) 1y % 3y % 5y % Expense Ratio(%)
SBI Tax Advantage Fund - Series III (G)21.6225.2715.6112.482.9
SBI Tax Advantage Fund - Series II (G)25.8620.6113.3112.222.94
DSP Tax Saver Fund (G)6102.9916.1511.1710.671.9
BOI AXA Tax Advantage Fund (G)255.1916.1112.668.512.64
JM Tax Gain Fund (G)34.6315.8213.9510.132.43

What are ELSS Funds?

Equity Linked Saving Scheme (ELSS) funds are equity mutual funds with added tax benefit thrown in. The idea of ELSS was to encourage the habit of long term equity investing in retail investors. ELSS funds have a compulsory lock in period of 3 years which is due to the added tax benefit that this product offers. ELSS gives you tax benefit on the amount invested. For example, if you are in the 30% tax bracket and you invest Rs150,000 in an ELSS fund then Rs45,000 (30% of 1.50 lakhs) will be reduced from your total tax. Of course, this is a blanket limit which also includes a plethora of other investments like PPF, NSC, 5-year bank / post office FDs, insurance premiums, tuition fees etc. Tax benefits under Section 80C for ELSS are distinct from the tax benefits on dividend and capital gains. Where ELSS scores over other equity funds are in the special tax exemption under Section 80C up to an investment of Rs 1.50 lakhs each year. Other benefits on tax on dividends and capital gains continue.

ELSS funds combine three things to benefit investors. They combine the long term wealth creation potential of equities, the tax exemptions under Section 80C and the longer term approach facilitated by the mandatory 3 year lock in period. Section 80C is a special exemption given to tax payers up to a limit of Rs150,000 per annum. Each year you can buy ELSS funds and get exemptions up to Rs1.50 lakhs on it. Also, you can invest in ELSS either in lump sum or as SIP and both are eligible for tax exemption as long as the investment is done in the same fiscal year. This section, however, includes a lot of other items. Section 80C includes your payment of LIC premium, contribution to provident fund, payment of tuition fees for your children, principal repayment on your home loan and long term bank FDs among other things. One of the key inclusions in Section 80C is the Equity Linked Savings Scheme (ELSS). This is like any other equity mutual fund with the only difference being that there is a compulsory lock-in of 3 years from the date of the investment. These mutual fund units cannot be redeemed before the completion of 3 years. What matters here is that the tax exemption under Section 80C substantially enhances the effective post-tax yield on an ELSS as compared to a normal equity fund.

What are the types of ELSS Funds?

It needs to be noted at the outset that ELSS funds are essentially equity funds. Within the gamut of equities, ELSS funds can take different forms. Here are few of them.

  • Tax saving index fund are equity oriented funds which predominantly invest in the index stocks only. It is a passive fund and purely tries to replicate the index which could be the Nifty or Sensex and only carries market systematic risk.
  • Tax savings sector funds are tied to a particular sectoral theme like banking, pharma, IT or even capital goods. These sectoral tax saving funds also are subject to a lock in period of 3 years and offer the Section 80C tax benefit.
  • Tax savings fund can also take the form of thematic funds which invest in a particular theme. Themes are normally broader categorization compared to industries and a typical theme can comprise of 2 or 3 sectors. For example, “Rate Sensitivity” as a theme can comprise of banks, NBFCs, auto and realty stocks.
  • One can also look at mid cap and small cap approach for ELSS funds. In fact, a mandatory lock in of 3 years would serve these mid cap and small cap funds quite well as such funds have the propensity to be very volatile in the short term to medium run.

As a matter of investment philosophy, try to look for ELSS funds that have a diversified portfolio or even a multi-cap portfolio, so that you don’t become a victim of concentration risk in your portfolio. After all, mutual funds are all about diversification and therefore a diversified fund would serve you best.

Who should invest in ELSS Funds?

ELSS funds are tax saving funds so it can be for anyone looking to save tax. Any tax assessee can use the ELSS tax exemption within the outer limit of Rs1.50 lakhs prescribed by Section 80C of the Income Tax Act. The ELSS funds will be a good investment choice for the following category investors.

  1. ELSS is a great tax saving product for first time tax payers. If you have just joined a job and need to plan your taxes then ELSS is like hitting two birds with one stone. On the one hand the tax exemption reduces your tax burden and on the other hand the equity component of ELSS funds is instrumental in creating wealth.
  2. If currently there is a gap in your Section 80C exemption which is not filled up by your routine provident fund and insurance premiums, then your first choice should be ELSS funds. They combine wealth creation with tax saving and in fact, the yields on ELSS funds are very attractive if you factor in the benefits of the tax exemptions too.
  3. ELSS funds are also a very good option for investors who want to start financial planning for long term goals but have not been able to allocate funds for the same. Since Tax saving ELSS funds are essential to save tax, they play the dual role of compulsory savings and tax planning.
  4. You can also buy ELSS via the systematic investment plan (SIP) model. That means you can allocate a fixed sum each month to synchronize with your income flows and get the same benefits over time. For regular salary earners, the ELSS is a great means of matching outflows with inflows and creates a disciplined process to generate wealth in the long run. You can buy ELSS funds online or offline.

Why should you invest in ELSS Funds?

ELSS funds are essentially equity so they present a good means of saving tax as well as creating wealth in the long run. In fact, the discipline of regular saving and putting money in equities is a big advantage that ELSS funds offer. Here are 3 principal reasons why you should invest in ELSS funds

ELSS fund managers can afford to take a truly long term view

One of the key advantages that ELSS offers is the discipline of regular saving and equity investment. However, there is an additional advantage that is often overlooked. Fund managers have the tendency to churn portfolios in a quest to book profits to keep the MTM position as favourable as possible. ELSS is slightly different. Since investors are locked in for 3 years the fund manager is assured of the longevity of the investment. This induces the fund manager to take a long-term view of investing. It tends to benefit investors in the long run since the longer term approach means that unnecessary churn is reduced and the costs are lower.

You can get the benefit of rupee cost averaging through regular ELSS Fund SIPs

Ideally, even an ELSS should be done through the SIP route. It has a few distinct advantages. It helps you to match your outflows with your inflows and instills a discipline to start planning taxes in a systematic manner rather than bunching at the end of the year. You have the added benefit of rupee cost averaging; which implies that you get better value when the NAV goes up and more units when the NAV goes down. There is another advantage in adopting the SIP route. The 3-year lock in commences from the date of investment. Hence an ELSS SIP is better than bunching your ELSS investment at the end of the year. You don’t need to go running around in search of the corpus and your ELSS gets freed up each month as each SIP completes 3 years of lock in. That gives you more flexibility.

ELSS can substantially enhance your effective yield on investments (post-tax)

To understand this benefit of effectively yield, let us look at two investors who invest in two funds with the same portfolio. The only difference is that the second fund is an ELSS fund.

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
Revised CAGR Returns after considering Section 80C 20.6% Revised CAGR Returns after considering Section 80C 35.8%

The above table captures the difference that the Section 80C rebate offers to Investor B. Since, Investor B gets a 30% tax rebate (we have ignored cess and surcharge for simplicity) in the year of investment it reduces Investor B’s outlay to Rs70,000 (net of exemption). This makes a massive difference to the CAGR returns over 3 years, although both the funds have performed similarly in NAV terms due to their mirror portfolios. That is the power that ELSS offers. Effective yields go up sharply after considering tax shields.

Things to consider before investing in ELSS Funds

To begin with all the typical considerations of any equity fund like returns, risk profile, portfolio quality, consistency of returns etc will have to be considered. In addition, you need to take four more key decisions when it comes to investing in ELSS funds

  • Should I fill up the entire balance limit of Rs1.50 lakh with ELSS funds for Section 80C? The answer is to be driven by your financial plan. Start off with your financial plan and decided what should be your allocation to equities. Your ELSS cannot violate your outer limit for equity allocation and that should drive your ELSS investment
  • Should you adopt a lump sum route or a SIP route for investing in ELSS? That is a matter of choice and convenience. However, by adopting a SIP route, you get the added benefits of being able to synchronize your outflows with your inflows. In addition, since you are spreading your investment across the whole year, the rupee cost averaging will work in your favour.
  • Should I redeem ELSS funds once the 3 year lock in period is over? There is no compulsion because you can hold the ELSS funds for as long as you want. Since the lock in period is over it is like any other equity fund as long as performance parameters are looked at. The other question, is whether one should buy more ELSS funds than is warranted by the Section 80C limits? There is no reason for you to lock in your funds for 3 years when you should be able to get similar returns in diversified equity funds.
  • Look at the pedigree of the AMC that is issuing the ELSS fund. Any equity fund with a very small corpus finds it hard to sustain for a long time. Focus on ELSS funds from large AMCs and an AUM of at least Rs1000 crore to begin with. Smaller AMCs tend to outperform due to a smaller AUM, but that is not the way you should be selecting.

How much tax can I save by investing in ELSS?

The tax benefit on ELSS is covered by Section 80C of the Income Tax Act. That means ELSS funds are one of the assets that are eligible to get an exemption to the tune of Rs1.50 lakhs each financial year. Such exemption can be directly deducted from the taxable income of the person. How much tax you save will largely depend on a mix of various factors at play. Let us look at some of these key factors.

  • Firstly, your tax saving will be determined by the tax bracket that you are in. For example, if you are in the 20% bracket and if you invest the entire Rs1.50 lakh in ELSS funds then you get Rs30,000 as the tax deduction in the year. This tax deduction will be Rs45,000 if you are in the 30% tax bracket. Of course, there are surcharges and cess that will also make an impact on your tax paid but we shall leave them out for the sake of simplicity.
  • How much tax save will also depend on the limit of Section utilized. For example, if you have invested Rs1.10 lakh in other avenues of Section 80C like PPF and LIC premiums, then only Rs40,000 of investment in ELSS will be tax eligible. You can invest more than that in ELSS but that will not offer you any tax rebate.
  • Should you opt for a dividend plan in an ELSS? A dividend plan is a good way of monetizing a part of your ELSS investment but the risk is that it does not lead to wealth accumulation; which is the purpose. Also, while equity fund dividends are still tax free in the hands of the investor, they are subject to DDT at 10% plus cess and surcharge. You have to factor that cost in.

What are the other benefits of investing in ELSS?

ELSS funds bring some unique benefits along with it. Tax exemption under Section 80C is the most obvious of them. But there are quite a few more critical benefits that you need to be aware of.

  • ELSS funds are equity funds and hence are useful as long term wealth creators. They may be volatile in the short term but like most equity funds then tend to create wealth over the long term.
  • The 3 year lock in period on ELSS puts a discipline in the investors. Equity funds are liquid from day 1 and so there is a tendency to book profits in a bull market or panic and exit in a bear market. The compulsory lock-in period of 3 years forces investors to take a long term view
  • Fund managers are able to take a long term view as they need not worry about keep liquidity available like in case of equity funds. Since redemptions are limited in case of ELSS funds, it enables fund managers to take a longer term view which works in favour of the investors in terms of long term returns.
  • One can structure ELSS also as SIPs. This not only synchronizes the ELSS outflows with the income flows but also gives an added advantage of rupee cost averaging (RCA). Over a period of time, this enables the fund investor to reduce the cost of acquisition and thus enhance the yield on investments.
  • Compared to other tax saving instruments under Section 80C, the ELSS funds have the lowest lock in period of 3 years. Comparatively, the long term FDs are locked in for five years while PPF and ULIPs are locked in for atleast 5 to 7 years.

Why should I invest in ELSS when I have other tax saving investment options?

When it comes to Section 80C, ELSS is just one of the options available to you. There are other options like PPF, contributory PF, life insurance premium, ULIPs, long term bank FDs, tuition fee payments, home loan principal etc. While one must be driven by the overall asset allocation in deciding the extent of ELSS exposure, the ELSS option has some distinct advantages over the other options. Here are some of the key advantages in opting for an ELSS for your Section 80C.

  1. ELSS funds combine the twin benefits of wealth creation and tax exemption. If you look at other asset classes like PPF, long term FDs, post office long term FDs then none of these are wealth creators. Only ELSS is an equity driven long term wealth creator.
  2. ELSS lock in is much lower than other classes of tax saving instruments. For example, the PPF has a lock in period of atleast 7 years while the long term bank FDs and ULIPs have a lock in period of 5 years. Also, products like ULIPs have huge loading in the initial years and that takes them longer to break even.
  3. ELSS can give you the benefit of rupee cost averaging. Even if you contribute to your PPF or long term bank FDs on a regular basis, there is no unique advantage that you get. In the case of ELSS, if you adopt a SIP approach then your cost acquisition comes down and that enhances your return on investment.
  4. There are no upper limits on investing in ELSS. For example, investments in PPF and long term bank FDs in any year are subject to upper limits. There is not such upper limit in case of ELSS funds and the limit can be extended much more than you may require. It is a different matter if you should invest or not!
  5. ELSS done through SIPs gel better into the financial plan of an individual. This ensures that your tax planning syncs appropriately as a subset of your overall financial plan.

An ELSS offers some unique advantages like shorter lock-in period, better wealth creation and a better fit to long term financial goals.

Is it recommended to make lump sum investments in ELSS funds or do a SIP?

An investor looking to save tax via ELSS funds can allocate funds in a variety of ways. If you have a lump sum amount with you, then you can invest in bulk or you can also go to your AMC and register a systematic investment plan (SIP) on the ELSS fund. The 3-year lock in period for these SIPs will kick in from the date of the SIP investment. However, given a choice, it is recommended to adopt a SIP approach to investing in ELSS funds. Here is why…

What are the benefits of SIP in ELSS?

  • By adopting an SIP approach, you are able to better synchronize your outflows and your inflows. Your tax saving activity becomes more organized and you do not have to rush around for arranging funds at the end of the year.
  • An SIP approach gives you the benefit of rupee cost averaging. That means when NAVs go higher you get more value and when NAVs come down you get more units. This formula is very useful in volatile markets as it enables you to bring down your cost of acquisition and improve your ROI.
  • A SIP approach to ELSS investing enables you to better manage the liquidity of your ELSS investments. Since the ELSS has a mandatory 3 year lock in period, the SIP ensures that in the third year, each month the SIP equivalent gets freed up. This helps in better liquidity management.
  • Tax liability for the full year can be hard to judge as you may get increments during the year. In that case, your tax liability for the full year could go up drastically. That means a lump-sum investor will be in for a shock. However, a SIP approach will be more flexible in such cases.

Should my first mutual fund investment be in ELSS?

That is actually a very good idea. Why do we invest in mutual funds? The reason is to get the benefit of diversified risk management and higher comparable returns over a period of time. As a first time investor, you may not have the expertise to invest in direct equities. Hence mutual funds may be the right way to start. Even within mutual funds, equity funds may be the right choice as they combine the ability to generate returns in the long run. But what will be your trigger for investing in equity funds? One such trigger can be tax planning.

When we start earning income, we are authorized and obligated to save our taxes. ELSS funds offer tax exemption under Section 80C of the Income Tax Act to the extent of an outer limit of Rs1.50 lakhs per annum. Here you can hit two birds with one stone. Use ELSS funds as your entry point to get into equity funds. The compulsory lock in of 3 years will keep you away from the temptation of exiting your equity fund early. At the same time, once you see the returns on an equity fund, you will have greater conviction to invest in equity funds at a later stage and use that for financial planning.

ELSS funds also have some distinct advantages over other classes of instruments that are eligible for Section 80C. For example, ELSS is the only instrument among Section 80C instruments that is a long term wealth creator. It fits in ideally when you are young and your risk appetite and risk capacity are quite high. Also, you need to create wealth in the long term and the earlier you start the better it is. Also, the lock in period is just 3 years and so you can churn your money more efficiently. That is surely a good starting point for investors.

Are earnings from ELSS funds taxed?

One needs to understand that earnings from ELSS funds are defined in a variety of ways. There is dividend income, there are short term gains and then there are long term gains. Of course, short term gains are not applicable to ELSS since these funds have a mandatory lock in period of 3 years and any holding in equity funds of more than 1 year is necessarily classified as LTCG. So, let us look at dividends, capital gains and redemption reinvestments and the tax implications.

  • It is quite common to opt for dividend plans of ELSS as it helps to monetize part of the fund during the lock in period. However, from the point of view of long term wealth creation, dividends are not a great idea. How are dividends on ELSS funds taxed? Dividends are tax free in the hands of the investor. However, dividends declared by equity funds are subject to Dividend Distribution Tax (DDT) at the rate of 10% plus surcharge and cess, which takes the effective rate to 11.648%. To that extent, your net returns are impacted.
  • What about LTCG on ELSS funds. In case of equity funds, the definition of LTCG is a holding period of more than 1 year. Since ELSS funds are subject to a mandatory lock in period of 3 years, then are by default LTCG. Any gains on ELSS funds are exempt up to Rs1 lakh in any financial year. Any gain beyond that will be taxed at a flat rate of 10% without any indexation benefits. This is effective from April 2018.
  • Losses on ELSS funds can be booked and either adjusted against other capital gains or can be carried forward for a period of 8 assessment years. At the end of 3 years, the redemption proceeds can again be invested in the ELSS fund and the benefit of Section 80C can once again be claimed in that particular year by rolling old funds.

What is the lock-in period in ELSS funds and is there an exit load?

The advantage of an ELSS fund is that the lock in period is the lowest among the tax saving instruments under Section 80C of the Income Tax Act. An ELSS fund has a mandatory lock in period of 3 years from the date of investment. That means, if the SIP approach is adopted for an ELSS , then the lock in will commence from the date of the SIP for each installment and the lock in will be removed exactly 3 years after that. In comparison, long term bank FDs has a lock in period of 5 years while PPF has a lock in of 7 years. Effectively, by the time you can churn your PPF money twice you can churn the ELSS money five times leading to substantially levels of tax breaks. Normally, equity funds have an exit load for exiting before 1 year. However, since the ELSS funds have a mandatory lock in of 3 years, they are normally not subject to any exit load.