What are tax saving mutual funds and how do they work?

Tax saving mutual funds, also known as Equity Linked Saving Scheme or ELSS, offer the dual benefits of higher returns and tax saving through deductions up to Rs 1.5 lakh under section 80C of the Income Tax Act.

Shortest lock-in:

ELSS has the lowest lock in period of three years (among section 80C investment options), compared to 5 years for bank fixed deposits and post office schemes, and 15 years for Public Provident Fund. Gains from ELSS are taxed as Long-Term Capital Gains. Annual gains above ₹ 1,00,000 are thus taxable at 10 per cent, while short-term capital gains are taxed at the rate of 15 per cent. You cannot liquidate these funds before the three-year lock in period ends, so if you are looking for short term liquidity, ELSS is not for you. You also benefit from compounding, particularly if your investment horizon is long term (between five to 15 years) in nature. Hence even though the lock in period in ELSS is three years, it is always advisable to invest for the long term for maximum benefits.

The SIP factor:

Apart from lump sum investment, ELSS also offers the option to invest through a systematic investment plan or SIP, where the minimum investment is Rs 500 per tranche, payable monthly, quarterly or half yearly, without an exit or entry load. While this helps build fiscal discipline and avoids the trauma of last minute lump sum investment to save taxes, remember that each tranche of an SIP is locked in for three years from the date of investment.

Higher Returns:

ELSS usually deliver 10-12% p.a. returns in a longer period, which is way above the single digit returns offered by other traditional instruments like bank FDs, PPF and pension schemes. This of course comes with a correspondingly higher rate of risk. ELSS is therefore meant for those who want to save tax and get higher rates of return than other investments. Because of the equity exposure, ELSS has a higher risk than traditional investments, but this usually evens out in the long term.

80C limit:

Another thing to keep in mind that section 80C of the Income Tax Act allows a maximum deduction of Rs 1.5 lakh across your investments, so if you already have investments of 1.5 lakh in other funds or instruments like PPF, postal savings schemes, national savings certificates, life insurance, and other tax saving assets under section 80C, you cannot claim tax deductions for your ELSS. However, you can invest any amount in ELSS.

ELSS is thus a good bet if you have a reasonably high appetite for risk, and don’t want to lock your funds in for the long term through other 80C investment options.