ELSS mutual funds: features, benefits and investment tips

The primary objective of investing is to create a safety net and potentially grow wealth over time. However, the taxes you pay on your investments eat into your real returns. Thus, it is important to strike a balance between investment avenues that offer high growth potential and those that offer tax efficiency.

An avenue that can offer both advantages is an Equity Linked Savings Scheme (ELSS) mutual fund. Such funds invest predominantly in equities, offering long-term wealth-building potential. Moreover, investments of up to Rs 1.5 lakh in a financial year are eligible for tax exemption under Section 80C of the Income Tax Act, 1961.

The benefits of this tax-saving mutual fund have made it popular among long-term investors. This article will help you understand the features of ELSS funds so you to make an informed investment decision.

Table of contents

• What are ELSS Funds
• Features of ELSS mutual funds
• How do ELSS funds work?
• Who should invest in ELSS mutual funds?
• How should you invest in an ELSS fund?
• Why should you invest in ELSS tax-saving mutual funds?
• Tax benefits of ELSS Mutual Funds
• Things to consider before investing in ELSS Funds
• What are the risks associated with ELSS Funds?
• How ELSS funds may help in growth contribution
• Comparing ELSS with other tax-saving instruments
• What is lock-in period in ELSS funds
• How does the lock-in period of 3 years work?
• Method of Investing and Lock-in Period
• Benefits of the lock-in period in ELSS fund
• How ELSS fund is promoting disciplined investing approach?
• What to do when the ELSS 3-year lock-in period ends?
• What happens to ELSS after 3 years?
• Common myths about ELSS funds
• How to tackle these myths about mutual funds

What are ELSS Funds

ELSS funds are equity mutual funds that invest at least 80% of their portfolio into equities and equity-related instruments. This means your investment is primarily in the stock market.

Equities have historically delivered higher returns in the long term than traditional fixed-income instruments (though it’s important to note that past performance does not predict future outcomes and mutual fund returns are subject to market risk). This gives ELSS funds the potential to outperform inflation and build wealth over time.

Additionally, investments in ELSS funds are eligible for tax deductions under Section 80C of the Income Tax Act, with a maximum deduction limit of Rs. 1.5 lakh per financial year. This deduction can significantly reduce your taxable income, thereby lowering your overall tax liability.

Unlike most other equity mutual funds, ELSS funds come with a lock-in period of three years, during which you cannot access your money. This encourages long-term investing and can make such funds suitable for goals that have an investment horizon of multiple years.

Features of ELSS mutual funds

The following features make ELSS mutual funds a compelling choice for investors seeking tax-efficient growth:

• Equity investments: ELSS funds must invest a minimum of 80% of their total assets in equities and equity-related instruments. This gives such funds high growth potential over time.
• Diversified portfolio: Investments can be spread across sectors and market capitalisations (large-cap, mid-cap, and small-cap). Diversification helps spread risk and mitigate the impact of underperformance in one area on the entire portfolio.
• Tax benefit: Investments of up to Rs 1.5 lakh in ELSS funds are eligible for tax deductions under Section 80C of the Income Tax Act, 1961.
• Relatively short lock-in period: ELSS funds have a mandatory lock-in period of three years. This is shorter than the lock-in periods of other tax-saving investment options. For instance, public provident funds have a lock-in period of 15 years and National Savings Certificate investments have a lock-in of five years.
• Market-linked returns: The returns from ELSS funds are linked to the performance of the underlying equity markets. This means such funds offer high growth potential but also entail high risk.
• Open-ended structure: ELSS funds are open-ended, meaning investors can enter the fund at any time. However, they can only redeem units after three years.
• No upper investment limit: There is no maximum limit on the amount you can invest in ELSS funds. However, the tax deduction under Section 80C is capped at Rs. 1.5 lakh. This is a combined cap for all investments done under Section 80C. So, you may invest that amount in ELSS alone, or more than one avenue.

How do ELSS funds work?

ELSS funds, like all mutual funds, pool investments from various individuals and invest the money in a diversified basket of securities, most of which are equity and equity-related instruments. Skilled fund managers conduct thorough market research and analysis to select stocks with growth potential. They also manage the portfolio, buying and selling securities when needed.

The primary objective of these funds is to generate long-term capital appreciation for investors by tapping into the growth potential of the stock market.

Read Also: ELSS vs SIP: Key Differences and Which Is Better?

Who should invest in ELSS mutual funds?

ELSS mutual funds can be suitable for a wide range of investors, including the following types:

• Salaried individuals: ELSS funds offer a way to diversify your investments and potentially earn higher returns through exposure to the equity markets. Moreover, ELSS funds offer systematic investment plans (SIPs), wherein you can invest a fixed amount at regular intervals (daily, weekly, monthly, etc). This can make investing affordable.
• First-time investors: ELSS funds can provide an entry point into equity investing and mutual funds. Regular investing through SIPs can be a convenient way for beginners to start investing with smaller amounts.
• Taxpayers seeking long-term growth: ELSS funds can be a suitable option for those seeking tax deductions under Section 80C while aiming for long-term wealth creation.
• Investors looking for diversification: If you have a predominantly fixed-income portfolio, ELSS funds can add a layer of diversification.

How should you invest in an ELSS fund?

Investing in an ELSS fund involves a few simple steps:

• Choosing a scheme: Research and select an ELSS fund. Consider factors such as the fund's past performance, expense ratio, investment strategy, and fund manager's track record.
• Decide how to invest: There are two primary ways to invest in ELSS funds.
  • Lumpsum: You make a one-time investment, typically a large sum.
  • SIP: Invest a fixed amount at regular intervals (monthly, quarterly, etc.).
• Investment platforms: Once you select an ELSS fund, you can visit the website of the asset management company that runs the scheme. You can also invest online or offline through the asset management company , distributors or aggregator platforms.

Why should you invest in ELSS tax-saving mutual funds?

Here are some reasons you should consider investing in ELSS tax-saving mutual funds:

• Tax saving: By investing in ELSS, you can claim deductions up to Rs. 1.5 lakh under Section 80C of the Income Tax Act.
• Low minimum investment amount: ELSS mutual funds allow investments for as low as Rs. 500 as required under Income Tax Act. 1961.
• Flexibility of SIP investments: Alongside lumpsum investments, ELSS funds offer the convenience of SIPs.
• Continued investment after lock-in: After the three-year lock-in period, you have the flexibility to either redeem your investments or continue to stay invested.

Tax benefits of ELSS Mutual Funds

ELSS mutual funds stand out as a tax-efficient investment avenue, offering distinct advantages under the Indian Income Tax Act:

• Deduction: Investments in ELSS funds are eligible for tax deductions under Section 80C. Apart from this, profits earned on ELSS investments are eligible for long-term capital gains (LTCG) tax, which is more favourable than short-term capital gains tax. This is because there is a mandatory three-year lock in. LTCG tax is levied on equity investments held for a year or more. The 2024 Union budget has proposed that the LTCG tax rate be increased from 10% to 12.5% (plus applicable surcharges and 4% cess). It has also raised the exemption limit from Rs. 1 lakh to Rs. 1.25 lakh.
• In comparison, short-term capital gains (STCG) tax is levied on equity investments held for less than a year and the tax rate has been increased from 15% to 20% in the 2024 Budget.

Things to consider before investing in ELSS Funds

Here are the factors you should consider so that your investments align with your financial goals and risk tolerance:

• Fund returns and performance: Compare the fund's historical performance with its benchmark and peers. Do note, however, that past performance may or may not be sustained in the future.
• Expense ratio: The expense ratio is the percentage of your invested amount that goes into covering the fund’s operational costs.
• Financial parameters: Look at risk metrics such as standard deviation (measures volatility), Sharpe ratio (risk-adjusted returns), alpha (excess return compared to the benchmark), and beta (measures sensitivity to market movements).
• Fund manager's expertise: Research the fund manager's experience, investment philosophy, and track record.

How ELSS fund may help in growth contribution

Equity Linked Savings Schemes (ELSS) are diversified equity mutual funds with a lock-in of three years. They help investors by combining tax-saving benefits under Section 80C of the Income Tax Act, 1961, with the potential for long-term wealth creation. Since ELSS invests mainly in equities, it offers potential opportunities for capital appreciation while encouraging disciplined investing through SIPs. The mandatory lock-in also helps investors stay invested. By channeling savings into equity markets, ELSS may contribute to both: potential individual financial growth and the broader economy through productive capital allocation.

Comparing ELSS with other tax-saving instruments

Feature	ELSS (Equity Linked Savings Scheme)	PPF (Public Provident Fund)	Tax-saving FD	NPS (National Pension System)
Lock-in period	3 years	15 years (partial withdrawal allowed after 5 years)	5 years	Till age 60 (partial withdrawal allowed in specific cases)
Return type	Market-linked (equities)	Fixed, government-backed	Fixed, varies by bank	Market-linked (equity + debt mix)
Risk level	Moderate to very high (market risk)	Very low (sovereign backed)	Low (bank FD safety)	Moderate (depends on asset allocation)
Tax benefit (80C)	Up to ₹1.5 lakh	Up to ₹1.5 lakh	Up to ₹1.5 lakh	Up to ₹1.5 lakh + additional ₹50,000 under Sec 80CCD(1B)
Tax on returns	Capital gains tax applicable	Interest is tax-free	Interest taxable as per slab	Maturity partly taxable; annuity fully taxable
Liquidity	High after 3 years	Limited	Medium (after 5 years)	Low (long-term retirement focus)

Read Also: NPS vs ELSS: Key Differences and Which is Better for Tax Saving?

What is lock-in period in ELSS funds

ELSS (Equity Linked Savings Scheme) funds are mutual funds that invest in equities and offer potential tax benefits to investors. They are designed to promote savings and investment among investors, while also providing tax deductions under Section 80C of the Income Tax Act, of 1961.

ELSS funds are unique in that they have a lock-in period of three years, which means that investors cannot withdraw their investments before the completion of three years from the date of investment. The compulsory lock-in period is intended to encourage investors to stay invested for the long-term and to discourage short-term trading.

Additionally, like other mutual funds, even ELSS funds are managed by professional fund managers who invest the pooled money in a diversified portfolio of equity stocks. The fund managers aim to generate potential capital appreciation by investing in a mix of equity and equity-related instruments, while also ensuring that the investments are aligned with the objectives and risk profile of the scheme.

How does the lock-in period of 3 years work?

The three-year lock-in period for ELSS indicates that investments are ‘locked in’ – that is, they cannot be withdrawn before three years from the investment date. Once the 3-year lock-in period ends, you have the flexibility to redeem your investment, continue holding it, or switch to another fund (if the switch facility is offered by the asset management company).

Method of Investing and Lock-in Period

The functioning of the lock-in period is straightforward for lumpsum investments but differs slightly for SIPs. Here’s how it works:

Lumpsum investments: The lock-in starts from the date of the one-time investment.

SIP investments: Each installment has a separate 3-year lock-in starting from its respective date.

Example:

If you invest Rs. 10,000 in an ELSS fund on January 1st, 2024, you cannot withdraw this amount before January 1st, 2027.

If you invest in the same ELSS fund via SIP with monthly installments of Rs. 5,000, each installment will have its own 3-year lock-in period starting from the date of that specific installment.

*Example for illustrative purposes only.

Benefits of the lock-in period in ELSS fund

There are several features of ELSS funds over the lock-in period that may be beneficial for investors. These include:

• Commitment: Investors are expected to commit to keeping their funds invested for the entire lock-in period. Partial withdrawals or premature redemption is not allowed during this time.
• Tax benefits: ELSS investments offer tax benefits under Section 80C of the Income Tax Act, 1961. Investors can claim deductions of up to Rs. 1.5 lakh per financial year on the amount invested in ELSS schemes. Moreover, capital gains from ELSS schemes are classified as long-term capital gains. As per the latest Union Budget (2024), long-term capital gains of up to Rs. 1.25 lakh in a financial year are tax-exempt. Thereon, they are taxed at 12.5%.
• Long-term investment: ELSS is designed as a long-term investment vehicle. The lock-in period encourages investors to stay invested for a longer duration, which may help in generating potentially higher returns over time. This is because of the power of compounding. When realised returns are reinvested, they may go on to earn further potential returns. Over time, this may have a multiplier effect. The longer the investment horizon, the more significant the potential impact of compounding. A compound interest calculator might help you visualise this. You can input different investment horizons to see the resultant change in return potential to understand the potential benefits of long-term investing. A lumpsum mutual fund calculator may similarly help investors considering a one-time lumpsum investment.
• Flexibility: After the completion of the lock-in period, investors have the flexibility to either redeem their investment or stay invested in the ELSS scheme based on their financial objectives.

How do ELSS funds promote a disciplined investing approach?

How does the lock-in period in ELSS funds promote discipline? Lock-in periods in ELSS funds promote a discipline in the following ways:

• Encourages long-term investing: The lock-in period encourages investors to adopt a long-term investing approach, which can help them ride out short-term market volatility and potentially benefit from the power of compounding.
• Reduces emotional investing: The lock-in period helps investors avoid making emotional decisions based on short-term market fluctuations. Investors are less likely to panic and withdraw their investments during market downturns, which may help them avoid potentially significant losses.
• Helps investors avoid market timing: The lock-in period helps investors avoid trying to time the market, which can be a risky strategy. By staying invested for the long-term, investors might ride out interim volatility without trying to predict market movements.
• Promotes discipline: The lock-in period helps promote discipline among investors by restricting their ability to make frequent changes to their portfolio. This discipline helps investors stay focused on their long-term goals and avoid making impulsive decisions based on short-term market trends.

What to do when the ELSS 3-year lock-in period ends?

Once the 3-year lock-in period for your ELSS investment ends, you have the following options:

1. Redeem your investment:

• Full redemption: Withdraw all units in the fund.
• Partial redemption: Withdraw a portion while keeping the rest invested.
• Systematic Withdrawal Plan (SWP): Regularly withdraw fixed amounts (e.g., monthly, quarterly).

It is important to consider that upon redemption, capital gains will be subject to tax. An LTCG of 12.5% will be applicable on capital gains exceeding Rs. 1.25 lakh in a financial year.

2. Continue investing:

• Hold and grow: Retain your investment to benefit from potential market growth.

What happens to the ELSS investment after 3 years?

After your lock-in period ends, your money continues to stay invested. You can choose to withdraw the money if you wish to or stay invested if you are yet to reach your goal date.

Common myths about ELSS funds

Here are some common misconceptions about Equity-Linked Saving Scheme (ELSS) funds.

Myth 1: Higher-risk investments always result in higher returns.

Equity-Linked Saving Scheme (ELSS) fund is an equity-oriented mutual fund and hence, often associated with higher risk and potentially higher returns. However, returns are not guaranteed with ELSS funds, as the returns are linked to the market. As for the risk, they might be able to manage the risk, but not eliminate it, by diversifying investments across different asset classes (equity and debt).

Myth 2: Investing in ELSS requires big initial capital.

ELSS funds might be more flexible than many investors realise. You may only need a small amount of money upfront to invest in them. You can use Systematic Investment Plans (SIPs) to make smaller, consistent contributions at regular intervals, such as monthly.

Myth 3: ELSS Funds ensure tax-free returns.

ELSS funds might be considered as a suitable choice for saving taxes through mutual funds. However, there needs to be more clarity about the tax benefits they offer. It's important to understand that ELSS funds provide tax deductions under Section 80C of the Income Tax Act, 1961 allowing investors to claim a taxable income of up to Rs. 1.5 lakh. They do not guarantee tax-free returns but may offer certain tax benefits.

Myth 4: There are few choices for investing in ELSS funds.

ELSS funds might offer diverse investment options across different sectors and industries. Investors may have the flexibility to explore various sectors and industries based on their preferences and risk appetite.

Myth 5: ELSS funds may be more suitable for experienced investors.

ELSS funds might often be misunderstood as only suitable for experienced investors, but that might differ. These funds are designed to accommodate investors at all levels of expertise, from beginners to experienced. Additionally, investments in ELSS receive guidance from experienced fund managers to help navigate market trends, making ELSS accessible to a broader investor base.

How to tackle these myths about mutual funds

To dispel common misconceptions about mutual funds, consider these approaches:

• Seek expert guidance: Consult with financial advisers or fund managers who can offer tailored advice and address misunderstandings based on your financial objectives and risk profile.
• Learn the fundamentals: Familiarise yourself with how mutual funds operate, their categories, and their key features. Trusted financial resources like books, websites, and courses can help build your knowledge base.
• Leverage technology: Explore financial apps and platforms to monitor investments, compare funds, and access educational materials. These tools may make investing more accessible and informed.
• Start small: Begin with a small investment to help build confidence and practical understanding. Regular contributions through Systematic Investment Plans (SIPs) can help you start with minimal amounts.
• Diversify wisely: Reduce risk by allocating your funds across different mutual fund types, avoiding dependency on a single asset category.

What are the risks associated with ELSS Funds?

• Market risk – Returns fluctuate with equity market movements.
• Volatility risk – Short-term ups and downs are quite common.
• Fund manager/concentration risk – Performance depends on stock selection and portfolio mix.
• No guaranteed returns – Unlike fixed-return instruments, outcomes are market-linked.
• Lock-in impact – Three-year lock-in reduces premature exits but does not remove market risk.

FAQs

Can I withdraw my investments before the lock-in period is over?

No, investors cannot withdraw their investments before the three-year lock-in period is over.

Do ELSS funds offer any tax benefits?

Yes, ELSS funds offer tax benefits to investors under Section 80C of the Income Tax Act, 1961. Investors can deduct up to Rs 1.5 lakh per year from their taxable income by investing in ELSS funds.

Can I invest in ELSS funds through SIP?

Yes, many ELSS funds offer a Systematic Investment Plan (SIP) option, which is a convenient and affordable way of investing in mutual funds. You may also use an SIP goal calculator to evaluate your potential returns and effectively plan your investments.

What should an investor do when the lock-in period ends?

After the 3-year lock-in period, ELSS investors can redeem their investments fully or partially. You can also continue holding the investment to benefit from potential growth.

What happens to ELSS funds after lock-in ?

After your investment completes the three-year lock in period, it becomes liquid and can be redeemed at any time. You can choose to stay invested or redeem all or a part of your funds, depending upon your tenure, goals and overall investment strategy.

Is ELSS tax-free after the three-year lock-in?

The tax benefits on ELSS only apply to the invested amount and only investments of up to Rs. 1.5 lakh across eligible schemes under Section 80C of the Income Tax Act, 1961 can be reduced from your taxable income in every financial year. All returns are subject to long-term capital gains tax at redemption.

How do you break a three-year lock in of a mutual fund?

The 3-year lock-in period for ELSS is a regulatory requirement and cannot be broken.

What happens if you sell ELSS before the lock-in is over?

Selling ELSS units before the 3-year lock-in period is not possible. Consult a financial adviser and explore other options if you are in urgent need of funds during this period.