What Is ELSS (Equity Linked Savings Scheme) ?

When the time comes to file your income tax returns, wouldn’t you like to put your best foot forward? Wouldn’t it be nice if you had already invested in equity mutual funds that promise high returns and provide tax benefits under Section 80C of the Income Tax Act?

Equity-linked savings scheme (ELSS) is perhaps the only viable tax-saving investment to serve all these purposes. The amount you invest in ELSS schemes reduces your total income as per Section 80C of the Income Tax Act.

The government encourages ELSS investment by offering tax rebates to investors. When you invest in such schemes, your total taxable income falls. However, there is a limit of Rs 1.5 lakh for tax purposes. The units purchased cannot be redeemed, sold, or transferred for a period of three years.

(Read more: How to start an SIP investment?)

5 Reasons Why ELSS Should Be In Your Portfolio

• Tax savings:

The primary benefit of ELSS investment is in saving on income tax. Any dividend or long-term capital gain you derive out of your ELSS investment is tax-free. By investing in ELSS, you can simply reduce your tax liability by up to Rs 1.5 lakh a year.

• Lowest lock-in period:

Compared to other tax-saving instruments like National Savings Certificate (NSC) or bank fixed deposits, ELSS has the lowest lock-in period of three years. Public Provident Fund (PPF) investments have a lock-in period of 15 years, NSC has six years, and bank fixed deposits eligible for tax rebates are locked in for five years.

• Prospects of higher returns:

Equity investments can fetch you the highest returns. Studies have revealed that compared to other asset classes, equities have delivered the best returns. Since ELSS funds invest majorly in equities, you have every reason to expect a high return on investment which would also be inflation-adjusted. You can stay invested in an ELSS beyond the mandatory lock-in period of three years to make the most of your investments.

• Regular saving habit:

Since your ELSS investment is locked in for a period of three years, you can use it to your advantage by exhibiting the healthy habit of saving regularly. A systematic investment plan could work for you. You can set aside as little as Rs 500 a month and put it into ELSS. After completion of three years of the first investment, you will be able to reap the benefits of capital appreciation every month. (Read more: What is a systematic investment plan?)

• Gateway to equity:

For beginners, ELSS can be an excellent opportunity to taste success in the stock markets. A new investor may take heart from the fact that ELSS funds are professionally managed. Once you taste the success of a pure equity product like ELSS, it will induce you to try out other equity-linked products available in the market.

(Read more: Different kinds of mutual funds?)

How ELSS Scores Over Rivals

If you look closely, you will find that ELSS has two competitors—unit-linked investment plans (ULIPs) and the National Pension Scheme (NPS). All three schemes have partial or full exposure to equities and bring to the table the benefit of tax savings.

If you take the lock-in period into account, ELSS is a clear winner. ULIPs have a lock-in period of 10 years and you get the benefits of NPS only after reaching your full retirement age.

Besides, NPS is more of a retirement solution scheme, while ULIPs have low transparency and high costs. (Read more: What is a mutual fund?)

Are There Only Upsides To ELSS?

No. Any mutual fund investment is subject to market risks. This is more so in case of equities. Since ELSS invests majorly in equities, the chances of the fund not doing that great are high when the markets are not favourable. Besides, all risks associated with equity investment pertain to ELSS.

Moreover, some investors may find the lock-in period of three years too long.

Not all ELSS funds do well. Unlike other mutual funds, ELSS funds do not disclose where they are investing. There are some funds that invest in large-cap stocks, some in mid-caps, some in small-cap stocks, and some in mix of them. Investors commonly make the mistake of picking up a fund that is doing well. Ideally, you should compare a fund’s investment pattern to your risk appetite before choosing any fund.

If you are averse to risks associated with the stock markets or would not like to stay invested over a period of three years without getting any returns, ELSS is not for you.

(Read more: How to choose a mutual fund scheme?)

Bottom-line

ELSS is a favourite of taxpayers. It has every right to be so. It is true that ELSS brings in very handy tax saving benefits of up to Rs 1.5 lakh a year that no other asset class can. Yet, ELSS should be viewed as a good investment first and a tax-saver later. This is because it offers multiple benefits and should be in your portfolio well before the actual time of filing income tax returns.

Read about mutual funds prerequisites and tax aspects