How to claim tax benefits on mutual funds (ELSS)?

Equity-Linked Savings Schemes (ELSS) are a popular investment option in India, offering dual benefits of wealth creation potential in long term and tax savings. These mutual funds allow taxpayers to claim deductions under Section 80C of the Income Tax Act, 1961, under the old regime while also benefiting from equity-linked return. However, understanding how to claim these benefits effectively is crucial to optimising your financial outcomes.

This is a detailed guide on claiming mutual funds tax benefits, the taxation rules, and key considerations for ELSS investments.

• Table of contents

1. What are the tax benefits under Section 80C of the Income Tax Act, 1961?
2. Why should a taxpayer choose ELSS?
3. When can tax benefits on ELSS funds be claimed?
4. Common mistakes to avoid while claiming tax benefits on ELSS
5. How to claim tax benefits?
6. Comparison of ELSS with other tax-Saving instruments
7. Key factors influencing mutual fund taxation in India
8. How profits are generated in mutual funds

What are the tax benefits under Section 80C of the Income Tax Act, 1961?

Section 80C of the Income Tax Act, 1961 permits taxpayers to claim deductions of up to Rs. 1.5 lakh annually under the old regime on specific investments, including ELSS mutual funds. Here’s how these benefits work:

• Deduction limit: You can invest up to Rs. 1.5 lakh in ELSS funds annually and reduce your taxable income by the same amount.
• Lock-in period: ELSS investments come with a mandatory lock-in period of three years, which is shorter than other tax-saving instruments like Public Provident Fund (PPF) or National Savings Certificate (NSC).
• Long-term capital gains (LTCG): Gains from ELSS are taxed at 12.5% if they exceed Rs. 1.25 lakh in a financial year.

ELSS becomes a suitable option for individuals looking to save taxes while potentially earning higher returns compared to traditional fixed-income instruments.

Why should a taxpayer choose ELSS?

ELSS mutual funds stand out among other Section 80C of the Income Tax Act, 1961, investments due to their unique features.

• Return potential: Since ELSS invests predominantly in equity and equity-related instruments, it offers the potential for higher long-term returns compared to fixed-income options like PPF or NSC.
• Short lock-in period: The three-year lock-in period is significantly shorter than other tax-saving options such as PPF (15 years) or tax saver fixed deposits (5 years).
• Dual benefits: Investors not only save taxes but also benefit from capital appreciation over time.
• SIP option: Systematic Investment Plans (SIPs) allow you to invest small amounts regularly, making it easier to manage finances and cultivate disciplined investing habits.
• Tax efficiency: Dividends earned during the lock-in period are tax-free, and LTCG tax applies only if gains exceed Rs. 1.25 lakh annually.

For individuals with a high risk appetite and long-term investment horizon, ELSS combines long-term growth potential and tax savings.

When can tax benefits on ELSS funds be claimed?

Tax benefits on ELSS investments can be claimed in the financial year in which the investment is made. For example,

• If you invest Rs. 1.5 lakh in an ELSS fund during FY 2024–25, you can claim this deduction while filing your Income Tax Return (ITR) for that financial year.
• The lock-in period starts from the date of investment. However, even if you redeem units after three years, gains exceeding Rs. 1.25 lakh will be subject to LTCG tax at 12.5%.

Common mistakes to avoid while claiming tax benefits on ELSS

• Not understanding the lock-in period: ELSS funds have a mandatory lock-in of three years. Redeeming or switching units before completion of this period is not allowed. Each SIP installment is treated as a separate investment, and its three-year lock-in is calculated individually.
• Claiming deduction beyond the eligible limit: The maximum deduction available under Section 80C of the Income Tax Act, 1961, is ₹1.5 lakh per financial year. Any investment in beyond this amount does not qualify for additional tax benefits.
• Redeeming immediately after the lock-in: Exiting right after three years may not allow the fund sufficient time to realise its long-term potential. ELSS is primarily an equity-oriented fund and may be more suitable for long-term investors.

How to claim tax benefits?

Claiming tax benefits on ELSS investments involves a few straightforward steps.

1. Invest in eligible funds:

• Ensure that the mutual fund scheme qualifies as an ELSS under Section 80C of the Income Tax Act, 1961.
• Check details on the fund house’s website or consult your financial advisor.

2. Maintain investment proofs:

• Keep receipts or statements from your fund house as proof of investment.
• For salaried individuals, submit these proofs to your employer before the end of the financial year to avoid higher TDS deductions.

3. File ITR correctly:

• While filing your ITR, declare your ELSS investments under Section 80C of the Income Tax Act, 1961.
• Use ITR-1 if you have no capital gains or ITR-2 if you have redeemed units and realized gains.

4.Track capital gains:

• If you redeem units after three years, calculate LTCG accurately.

5. Automate with tools:

• Use tools like capital gains statements provided by platforms for accurate calculations.

These steps diligently will help you can ensure seamless claiming of your Mutual Funds Tax Benefits.

Comparison of ELSS with other tax-saving instruments

There are several tax-saving instruments under Section 80C of the Income Tax Act, 1961, for those opting for the old regime. Here’s how ELSS funds compare with them:

Public Provident Fund (PPF): PPF offers stability and fixed returns backed by government assurance, but it comes with a long 15-year lock-in, though partial withdrawals are allowed after a few years. ELSS, in contrast, has a shorter 3-year lock-in but carries market-linked risk as it invests primarily in equities.

National Savings Certificate (NSC): NSC provides fixed interest determined by the government, making it relatively predictable. However, its returns may be lower than the potential long-term gains from ELSS. NSC comes with a lock-in of five years.

National Pension System (NPS): NPS Tier-1 is also market-linked and does not offer fixed returns. However, it may be less volatile than ELSS because equity exposure under NPS Tier 1 is capped at 75%. It also offers the following tax benefits under the Income Tax Act, 1961:

• Contributions made by individuals are eligible for a deduction of up to Rs. 1.5 lakh under Section 80CCD(1), within the overall Rs. 1.5 lakh limit of Section 80CCE of the Act.
• An additional deduction of Rs. 50,000 is available under Section 80CCD(1B).
• Employers' contributions to NPS has some tax benefits.
• At retirement, up to 60% of the accumulated corpus is tax-free.

However, funds are locked in until the investor reaches the age of 60, with partial withdrawals allowed before that under specific circumstances.

Tax-saving Fixed Deposits (FDs): These have a 5-year lock-in and offer fixed interest rates. However, the interest earned is taxable, unlike ELSS, where long-term capital gains are taxed at 12.5% if they exceed ₹1.25 lakh per financial year.

In summary, while ELSS funds may be suitable for investors seeking long-term growth potential and a relatively shorter lock-in period alongside tax savings, other instruments may be suitable for relatively conservative investors looking for predictable returns and capital stability.

Key factors influencing mutual fund taxation in India

Understanding taxation rules is essential for optimising returns from mutual fund investments.

• Type of fund: Taxation differs for equity funds (like ELSS), debt funds, and hybrid funds.
• Holding period
  • Short-term capital gains (STCG) apply if equity fund units are sold within one year; taxed at 20%.
  • Long-term capital gains (LTCG) apply if units are held for over one year; taxed at 12.5% beyond Rs. 1.25 lakh annually.
• Dividends vs capital gains
  • Dividends are taxable as per your income slab.
  • Capital gains taxation depends on the holding period and type of fund.

How profits are generated in mutual funds

Mutual funds generate profits through two primary methods.

1. Dividends/interest income:

•  Funds distribute dividends from their earnings during the holding period.
• Post Budget 2020, dividends are taxable as per the investor’s income tax slab.

2. Capital gains:

• Profits earned when mutual fund units are sold at a price higher than their purchase price.
• Gains are classified as STCG or LTCG based on the holding period and other factors.

Conclusion

Investing in ELSS mutual funds not only helps reduce taxable income but also offers an opportunity for wealth creation through equity-linked returns. With its short lock-in period and potential for high returns, ELSS stands out among other Section 80C of the Income Tax Act, 1961, options like PPF or NSC. However, understanding how to claim these benefits—whether through proper documentation or accurate ITR filing—is crucial for optimising investment outcomes.
Moreover, investors must remain mindful of taxation rules related to LTCG and dividends while planning their withdrawals post-lock-in period. Tools like automated capital gain statements can simplify this process further.

FAQs:

Do mutual funds require us to pay taxes on them?

Yes, mutual funds are subject to taxation based on their type (equity or debt) and holding period. For equity-oriented funds like ELSS.

• STCG is taxed at 20%.
• LTCG beyond Rs. 1.25 lakh is taxed at 12.5%.

What considerations should one make before selecting mutual funds that save taxes?

The five factors to be considered are -

• Risk appetite
• Lock-in period
• Historical performance
• Expense ratio
• Fund manager expertise

Can investing in mutual funds help me receive an income tax refund?

Yes, by investing in eligible schemes like ELSS under Section 80C of the Income Tax Act, 1961, you can reduce your taxable income and potentially receive a refund if excess TDS has been deducted.

Are investments made through MF subject to wealth taxes?

No, wealth tax has been abolished in India since FY 2015–16. However, capital gains earned from mutual funds are taxable as per applicable rules.

What is the capital gains tax exemption found in Section 54EA?

Section 54EA of the Income Tax Act, 1961, provides exemptions on long-term capital gains if they are reinvested into specified assets such as bonds within six months of sale. This does not apply directly to mutual funds but can be leveraged for other investments.

Do we need to show mutual funds in ITR?

Yes, all mutual fund transactions—whether dividends received, or capital gains realized—must be disclosed while filing ITR under relevant sections like "Income from Other Sources" or "Capital Gains.

How do I calculate LTCG tax on ELSS mutual funds?

Long-term capital gains (LTCG) on ELSS mutual funds are taxed at 12.5% without indexation if the gains exceed ₹1.25 lakh in a financial year. The holding period for ELSS is three years, and any redemption after this period qualifies as long-term for tax calculation purposes.

Can I claim tax benefits if I redeem my ELSS fund after lock-in period?

You may claim tax benefits under Section 80C of the Income Tax Act, 1961, only on the invested amount, not at the time of redemption. Once the ELSS lock-in period of three years is over, funds can be redeemed, and capital gains tax, if applicable, will be levied on the returns earned.

What documents are needed to claim tax benefits on ELSS in ITR filing?

To claim tax benefits on ELSS investments while filing income tax returns, you need proof of investment, such as an account statement or investment confirmation from the AMC. These documents verify the amount and date of investment under Section 80C for that financial year.

Is there any tax benefit if I invest in ELSS through SIP?

Yes, SIP investments of up to Rs. 1.5 lakh in a financial year in ELSS are eligible for tax deduction under Section 80C of the Income Tax Act, 1961 (for old regime), However, each SIP instalment has its own three-year lock-in period.

What is the tax implication if I switch from one ELSS fund to another?

Switching from one ELSS fund to another is treated as a redemption and a fresh investment. Therefore, applicable LTCG tax is levied on gains exceeding ₹1.25 lakh in a financial year. The new investment will trigger a fresh three-year lock-in period under the new ELSS scheme.

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Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views / opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.