What is an ELSS mutual fund?

If you're looking to invest in mutual funds with a tax-saving benefit, an **Equity Linked Savings Scheme (ELSS)** might be the right choice for you. ELSS is a type of mutual fund that not only offers potential for capital appreciation but also provides tax benefits under Section 80C of the Income Tax Act. In this blog, we will explain what an ELSS mutual fund is, how it works, and why it might be a good investment option for tax-saving and long-term wealth creation.

1. What is an ELSS Mutual Fund?

An **Equity Linked Savings Scheme (ELSS)** is a type of mutual fund that primarily invests in stocks or equity markets. ELSS funds have a lock-in period of 3 years, which means your money will be invested for at least 3 years before you can redeem it. This makes it a suitable option for those who are looking for long-term growth with tax-saving benefits.

ELSS funds are actively managed by fund managers who choose stocks to invest in, aiming to maximize returns for investors. Being equity-based, they offer higher returns compared to other tax-saving instruments, but also come with higher risk, as the value of your investment can fluctuate based on market conditions.

2. Tax Benefits of ELSS

One of the main reasons people invest in ELSS funds is the **tax-saving benefit**. Under Section 80C of the Income Tax Act, investments in ELSS funds are eligible for a tax deduction of up to ₹1.5 lakh per financial year. This means that if you invest ₹1.5 lakh in ELSS, your taxable income will be reduced by ₹1.5 lakh, which helps lower your tax liability.

The investment amount you put into ELSS is eligible for tax deductions, making it a great way to save taxes while also growing your money in the long run. The tax deduction is available only on the principal amount invested and not on the returns earned.

3. How Does an ELSS Work?

When you invest in an ELSS mutual fund, your money is pooled together with the investments of other investors and is then invested by the fund manager in a diversified portfolio of equities (stocks). These stocks are selected based on the fund manager's analysis of market trends, company performance, and growth potential.

ELSS funds work just like other equity mutual funds but come with the added benefit of tax-saving. The returns you earn from the investment are directly related to the performance of the stock market. If the market performs well, the value of your investment will increase, and if the market performs poorly, the value of your investment can decrease.

The fund manager makes all the investment decisions, so you don't have to worry about choosing individual stocks. However, the value of your investment will depend on the market's performance, so there is an element of risk involved.

4. Lock-in Period and Liquidity

One key feature of ELSS is the **lock-in period**. Unlike other tax-saving instruments like PPF (Public Provident Fund) or NSC (National Savings Certificate), which have lock-in periods of 5 years or more, the lock-in period for ELSS funds is only **3 years**. This means you cannot redeem your investment or withdraw your funds before 3 years, making it an ideal choice for long-term investors who are looking to save taxes and grow their wealth over time.

Although the 3-year lock-in period might seem like a limitation, it is relatively shorter compared to other tax-saving options. After the lock-in period ends, you can redeem your investment or continue holding it for potential future gains. If you choose to redeem after 3 years, you will have to pay capital gains tax (which we will discuss later in the blog).

5. Types of ELSS Funds

There are different types of ELSS funds based on their investment strategy, and you can choose the one that suits your risk tolerance and financial goals. The two main types of ELSS funds are:

• Large Cap ELSS Funds: These funds invest in large, established companies with a stable financial position. They tend to be less volatile and provide steady returns over the long term.
• Mid Cap and Small Cap ELSS Funds: These funds invest in mid-sized and smaller companies. While they have the potential for higher returns, they are also riskier due to their volatility.

Based on your risk appetite and investment horizon, you can choose the appropriate type of ELSS fund. If you are risk-averse and prefer stability, large-cap funds might be a good choice. However, if you're willing to take more risk for higher potential returns, mid-cap or small-cap ELSS funds could be more suitable.

6. Tax on ELSS Mutual Funds

The tax treatment of returns from ELSS funds depends on how long you hold the investment. After the 3-year lock-in period, if you redeem your investment, you will be subject to **capital gains tax**.

• Short-Term Capital Gains (STCG) Tax: If you redeem your ELSS fund before 3 years, the returns will be taxed as short-term capital gains at 15% (plus cess and surcharge).
• Long-Term Capital Gains (LTCG) Tax: If you redeem after the 3-year lock-in, the returns will be considered long-term capital gains. The first ₹1 lakh of long-term capital gains per financial year is tax-free, and any gains above ₹1 lakh are taxed at 10% (without indexation).

Therefore, while ELSS funds offer a tax-saving benefit, it’s important to consider the tax implications of your redemption to plan your investments efficiently.

7. Conclusion

ELSS mutual funds are a great investment option if you are looking to save taxes while growing your wealth in the long term. With their potential for high returns, tax benefits under Section 80C, and relatively short 3-year lock-in period, they offer a good balance of risk and reward. However, as they are equity-based, they also come with the risk of market fluctuations, so it’s important to carefully choose the right fund based on your risk tolerance and investment goals.