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 can reduce your effective 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 deduction 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 can 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?
- Taxation Rules of ELSS Funds
- How to Invest in ELSS Funds?
- What are the risks associated with ELSS Funds?
What are ELSS Funds
ELSS funds are equity mutual funds that invest at least 80% of their portfolio in equities and equity-related instruments, meaning your investment is largely linked to the stock market.
Equities have historically delivered higher long-term returns than traditional fixed-income instruments, giving ELSS funds the potential to outpace inflation and support wealth creation (though returns are subject to market risk and past performance does not guarantee future results).
Investments in ELSS are eligible for tax deductions of up to Rs 1.5 lakh per financial year under Section 80C of the Income Tax Act, which can help reduce taxable income.
These funds also have a three-year lock-in period, encouraging a long-term investment approach and making them suitable for goals with a multi-year horizon.
Features of ELSS mutual funds
The following features make ELSS mutual funds a relevant option 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 the potential for long-term growth.
- Diversified portfolio: Investments can be spread across sectors and (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 growth potential but also involve market 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. Fund managers conduct thorough market research and analysis to select stocks with growth potential. They also manage the portfolio, buying and selling securities based on market conditions and investment strategy.
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, quarterly etc.). This can make investing accessible.
- 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 to 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, depending on the scheme.
- Flexibility of SIP investments: Alongside , 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. Additionally, gains from ELSS investments are subject to long-term capital gains (LTCG) tax, as ELSS funds have a mandatory three-year lock-in period, which qualifies them for long-term capital gains taxation. LTCG tax is levied on equity investments held for more than one year. As per recent updates, the LTCG tax rate is 12.5% (plus applicable surcharge and 4% cess), with an exemption limit of Rs 1.25 lakh per financial year.
- In comparison, short-term capital gains (STCG) tax is levied on equity investments held for less than one year and the tax rate is 20%.
Things to consider before investing in ELSS Funds
Here are the factors to consider so that your investments align with your financial goals and :
- 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 (which measures volatility), Sharpe ratio (which reflects risk-adjusted returns), alpha (which indicates excess return compared to the benchmark), and beta (which 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 individual financial growth and the broader economic development through productive capital allocation.
Comparing ELSS with other tax-saving instruments
Understanding how ELSS compares with other tax-saving instruments can help you choose options that align with your investment horizon, risk appetite, and tax planning needs. The table below highlights the key differences across commonly used tax-saving avenues:
| Features | 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 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, 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, 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 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 and 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
The lock-in period in ELSS funds plays an important role in shaping investor behaviour and supporting long-term financial discipline. The following points highlight how this feature may benefit investors:
- Encourages disciplined investing: The mandatory lock-in period requires investors to remain invested for a fixed duration, helping reduce impulsive withdrawals.
- Enables tax efficiency: Investments of up to Rs 1.5 lakh per financial year qualify for deductions under Section 80C, while long-term capital gains up to Rs 1.25 lakh are tax-exempt, with gains beyond this taxed at 12.5%.
- Supports long-term wealth creation: Staying invested for at least three years allows investors to potentially benefit from compounding and market growth over time.
- Reduces impact of short-term volatility: The lock-in period limits reaction to short-term market fluctuations, encouraging a more stable investment approach.
- Provides post lock-in flexibility: After the three-year period, investors can choose to redeem, continue holding, or reallocate their investments based on their financial goals.
How do ELSS funds promote a disciplined investing approach?
Lock-in periods in ELSS funds promote 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:
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. LTCG of 12.5% will be applicable on capital gains exceeding Rs. 1.25 lakh in a financial year.
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 have not yet reached your financial goal, or switch to another scheme based on your investment needs. The investment will continue to remain market-linked, allowing it to potentially benefit from future market movements.
Taxation Rules of ELSS Funds
ELSS funds offer tax benefits at both the investment and redemption stages, making them a tax-efficient investment option under the Income Tax Act, 1961. The taxation of ELSS can be understood under the following aspects:
Tax deduction under Section 80C
Investments in ELSS funds are eligible for tax deductions of up to Rs 1.5 lakh per financial year under Section 80C of the Income Tax Act, 1961. This is a combined limit that includes other eligible instruments such as Public Provident Fund (PPF), National Savings Certificate (NSC), and tax-saving fixed deposits.
Taxation of capital gains
Since ELSS funds have a mandatory lock-in period of three years, any gains realised on redemption are classified as long-term capital gains (LTCG). Long-term capital gains from equity mutual funds, including ELSS, are:
- Tax-exempt up to Rs 1.25 lakh in a financial year
- Taxed at 12.5% (plus applicable surcharge and cess) on gains exceeding this limit
No short-term capital gains tax
Due to the three-year lock-in period, ELSS investments do not attract short-term capital gains (STCG) tax, as redemption before three years is not permitted.
How to Invest in ELSS Funds?
Investing in ELSS funds involves a structured approach that aligns with your financial goals, tax-saving needs, and risk appetite. The steps below outline how you can get started:
1. Define your investment objective
Identify your financial goals, investment horizon, and tax-saving requirements before selecting an ELSS fund.
2. Assess your risk profile
Evaluate your risk tolerance, as ELSS funds are market-linked and subject to fluctuations.
3. Select an appropriate ELSS fund
Compare funds based on factors such as past performance, expense ratio, portfolio composition, and fund manager track record.
4. Complete KYC formalities
Ensure your KYC is completed with the required documents such as PAN, identity proof, and bank details.
5. Choose the mode of investment
Decide between a lumpsum investment or a systematic investment plan (SIP) based on your financial situation and preferences.
6. Invest through a suitable platform
You can invest via asset management company websites, authorised distributors, or online investment platforms.
7. Monitor and review your investment
Periodically review your investment to ensure it remains aligned with your financial goals and risk profile.
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.
Conclusion
ELSS mutual funds combine the potential for long-term wealth creation with tax efficiency under Section 80C, making them a relevant option for investors looking to optimise both returns and tax savings. With their equity exposure, relatively shorter lock-in period, and disciplined investment approach, they can fit well within a long-term financial plan.
However, as with any market-linked investment, it is important to assess your financial goals, risk tolerance, and investment horizon before investing. A well-informed and consistent approach can help you make the most of what ELSS funds have to offer while staying aligned with your overall financial objectives.
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 investment horizon, goals, and overall strategy.
Is ELSS tax-free after the three-year lock-in?
The tax benefits on ELSS apply to the invested amount, with deductions of up to Rs 1.5 lakh available under Section 80C. Returns are subject to long-term capital gains (LTCG) tax, with gains up to Rs 1.25 lakh in a financial year being tax-exempt and gains above this taxed at 12.5%.
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. If you require funds during this period, you may need to consider alternative sources of liquidity.
