Among various equity mutual fund schemes, investments in equity-linked saving schemes or ELSS mutual funds are the only ones eligible for income tax benefits. Hence, these mutual fund schemes are popular among investors who wish to get tax benefits at the time of investments and create wealth in the long term. This blog focuses on the step-by-step guide to investing in ELSS mutual funds.
Before understanding the investing process, let us first understand what ELSS mutual funds are.
What are ELSS mutual funds?
An equity-linked saving scheme (ELSS) is an open-ended mutual fund scheme that invests a minimum of 80% of its total assets in equity and equity-related instruments. The scheme has a 3-year lock-in period and is eligible for deduction from taxable income under Section 80C of the Income Tax Act.
Factors to keep in mind for investing in ELSS mutual funds
For investing in ELSS mutual funds, you need to keep the following factors in your mind:
- Risk profile
ELSS mutual funds invest a minimum of 80% of their total assets in equity and equity-related instruments. Equities are volatile and subject to sharp swings in the short term. During uncertain times, equities can experience a sharp fall. For example, during the 2008 subprime crisis and the 2020 Covid-19 pandemic, the overall stock markets fell 50%. There have been a few periods wherein the overall market has experienced a more than 25% fall from the top.
However, as seen in the past, over time, stock markets recover all these losses and go on to make new highs. Equities have the potential to deliver inflation-beating high returns. Equities have the potential to create long-term wealth that can fulfill your financial goals. So, ELSS mutual funds are meant for investors with an aggressive risk profile. You should evaluate your risk profile before considering investing in ELSS mutual funds.
- Investment tenure
ELSS mutual funds have a lock-in period of three years. If you are investing through the systematic investment plan (SIP) mode, each SIP installment will have a lock-in period of three years. As discussed earlier, equity markets are volatile in the short term. Hence, you should invest in ELSS mutual funds only if your investment tenure is five years or more.
- Tax benefits at the time of investment
Investment in an ELSS mutual fund is eligible for deduction from taxable income under Section 80C of the Income Tax Act. The maximum deduction allowed in a financial year is the amount invested or Rs. 1,50,000, whichever is lower. The maximum limit of Rs. 1,50,000 is aggregate for investments made in ELSS, Unit Linked Insurance Plan (ULIP), Public Provident Fund (PPF), Employee Provident Fund (EPF), National Savings Certificate (NSC), etc. and other products covered under Section 80C.
- Taxation at the time of redemption
At the time of redemption, the long-term capital gain (LTCG) tax is applicable on ELSS mutual funds. In a financial year, the first Rs. 1 lakh long-term capital gain (LTCG) is exempt. The incremental LTCG is taxed at 10% without indexation benefit.
Investing in ELSS mutual funds: Lump Sum or SIP option
When investing in ELSS funds, you can either invest a lump sum amount or start a systematic investment plan (SIP). Due to the volatile nature of stock markets, it will not be a good idea to invest a lump sum amount in ELSS mutual funds. You can start a systematic investment plan (SIP) through which you can invest a fixed amount at fixed intervals for a specified period. Some AMCs give you the option to select the SIP investment frequency from daily, weekly, fortnightly, monthly, quarterly, etc. options.
Some AMCs also give you the option of choosing a flexible SIP. In this, you can increase the SIP amount by a specified amount or percentage annually.
Investing in ELSS mutual funds: Selection of scheme
While selecting an ELSS mutual fund scheme for investment, you need to consider the following factors:
- Expense ratio
The expense ratio directly reduces an investor’s overall returns. Hence, ideally, you should consider investing in an ELSS mutual fund with a low expense ratio. Consider investing in a direct ELSS mutual rather than a regular one, as it will have a lower expense ratio. Generally, the lower the expense ratio, the better, keeping other things constant.
- Scheme past returns
Check the past returns of the scheme and compare them with peers. The past performance will give you an indication of the track record. However, you should not use past returns to extrapolate future returns. The future returns will depend on factors like the overall economic scenario, the financial performance of portfolio companies, the valuation of companies and the overall market, and other factors.
- AMC and fund manager
You should always invest in the ELSS mutual fund scheme of an AMC of good repute. Find out about the fund manager’s qualification, experience, schemes managed earlier and their performance, etc.
