Equity investments are known to have the best return potential among investment vehicles. But investing in stocks has two main challenges – the risk associated with investing in them and the tax levied on returns. Equity-linked savings scheme (ELSS) could be a solution for both problems. Let’s understand ELSS in detail and see how it helps save taxes.
What is ELSS?
ELSS is a mutual fund that focuses its portfolio on equities. Over 65% of an ELSS fund’s portfolio is equities, and the rest goes to fixed-income investment options like debts and bonds. ELSS is the only mutual fund under section 80C of the income tax act, a section that describes ways to reduce your taxable income to save tax. Besides that, an ELSS has similar characteristics to an equity-focused mutual fund – it has a higher potential for growth but comes with higher risk.
As said above, tax-saving is the most sought after feature of an ELSS fund. Let’s understand how equities are taxed and see how ELSS funds help.
Taxation on equity returns
Equities are taxed when you sell them. Hence, the period in which you held a share is also considered. For example, if you buy a stock today and its price is appreciated, you won’t be taxed until you sell it as you have materialised the gain yet. However, when you sell a stock, you are taxed as per the time you have held the stock. Gains that you earn from holding the stock for less than 12 months come under short term capital gains, and gains from over 12 months are categorised as long term capital gains.
Short term capital gain tax is a flat 15%. However, for the long term, gains up to Rs.1 lakh are exempt from tax and post that, the tax rate is 10%.
Taxation on ELSS
Your gains from the ELSS fund will be taxed per the same rule as above. But ELSS has a lock-in period of three years. That means the profits only fall under the long term capital gains. Hence, gains above Rs.1 lakh are taxed at a flat 10%. But investing in equities in ELSS is beneficial in tax savings because it comes under section 80C of the income tax act. Under the act, your investment towards ELSS is tax-deductible for up to Rs.1.5 lakhs. You will not get the same benefit if you invest in equities directly. Furthermore, ELSS’s lock-in period of three years is the lowest among all investments under the act.
ELSS and risk
Investing in ELSS is hugely beneficial in mitigating the risk associated with investing in stocks as well. ELSS helps with this in two ways –
1) Since an expert manages the mutual fund, it is constantly monitored, and the fund manager will make all the necessary adjustments in the portfolio to ensure there is a lesser risk. You will miss out on this expertise if you choose to invest directly and make your own portfolio. The downside here is that you will be charged an expense ratio that goes towards compensating your fund manager.
2) Since you are investing in a bag full of securities, a dip in one or two will only slightly affect your overall portfolio. Here, the drawback is that not only losses but profits, too, will only have a diluted effect overall.
ELSS is a time-tested investment option that will help you save tax while earning profits from your equity investments. But make sure investing in ELSS is in line with your investment horizon before investing. For that, it is advisable to talk to your investment advisor before you choose ELSS.
