Equity Linked Saving Scheme (ELSS)

Introduction

There are different types of mutual funds available in the market. Based on the style of investing the 3 well known types of mutual funds are:

1. Equity Mutual Funds: These mutual funds invest a major portion of their corpus in equity shares and equity related instruments. The aim of this type of mutual fund is to generate long term capital appreciation for the investor. This type of mutual fund is suited to those investors who are looking for high returns and have a high appetite for risk.

 

2. Debt Mutual Funds: These mutual funds invest a major portion of their corpus in debt instruments like Government Bonds and Securities, Corporate Bonds, Fixed Deposits, Money Market Instruments etc. The aim of this type of mutual fund is to generate regular income for the investor. This type of mutual fund is suited for those investors who are looking to generate regular income for themselves without taking much risk.

 

3. Balanced Mutual Funds: These mutual funds invest a major portion of their corpus in a mix of equities and debt instruments. The distribution may be in the ratio of Equity 70 and Debt 30 or 50:50 or any other ratio as specified by the mutual fund. The equity component aims at generating long term appreciation and the debt component aims at providing stability and generating regular income.

Equity Linked Saving Scheme (ELSS) is also a type of mutual fund and falls under the Equity Mutual Fund category. An ELSS mutual fund invests major portion of its corpus into equity and equity related instruments. But there are some distinct features which makes ELSS plans different from other equity mutual funds.

Difference between ELSS Plans and Other Mutual Funds

There are 2 major features that make ELSS plans different from other mutual funds:

1. Income Tax Benefit: Investments made in ELSS plans are eligible for deduction from the taxable income under Section 80C of the Income Tax Act. There is no limit for investments in ELSS plans, but investments of up to Rs 1,00,000 qualify for income tax benefits. Investments made in normal mutual funds (other than ELSS plans) do not qualify for income tax deduction.

 

2. 3 Year Lock-in Period: Investments made in ELSS plans have a lock-in period of 3 years. In case of normal mutual funds this lock-in period is not there. In an ELSS plan every installments has a lock-in period of 3 years.

Example: Let us assume that a person starts investing on a monthly basis from Jan 2009. The lock-in period of the 1^st instilment (Jan 2009) will end in Jan 2012. The lock-in period of the 2^nd instalment (Feb 2009) will end in Feb 2012 and so on.

Features of an ELSS Plan

1. ELSS is an equity linked tax saving investment instrument.
2. Money collected under ELSS plan is mainly invested in equity and equity related instruments.
3. This financial product is more suited to those investors who are willing to take high risk and looking for high returns.
4. There is no upper limit on investments that can be made in ELSS. However investments upto INR 1,00,000 made in ELSS in a financial year qualify for deduction from taxable income under Section 80C of the Income Tax Act.
5. ELSS comes with a 3 year lock-in period.
6. Long term capital gains earned on investments from ELSS are tax free.
7. Also dividends earned from ELSS plan are tax free in the hands of the investor.
8. The other tax saving instrument that comes closest to comparison with ELSS is Unit Linked Insurance Plan (ULIP).

Options in an ELSS Plan

ELSS plans come with 2 options of growth and dividend.

1. Growth Option: If the investor selects growth option, he will not get any income during the tenure of the investment. He will get a lumpsum amount at the time of redemption or on maturity. In other words the investor will not get any returns till the time he is holding the instrument and the profit/loss is realized when the securities are sold/transferred.
2. Dividend Options: Dividends give income tax benefits to the investor.

 

3. Dividend Re-investment Option: If the investor opts for dividend re-investment option, then any dividends declared are re-invested on behalf of the investor. The investor can claim additional tax benefits on the re-invested dividend amount. For example let us assume that the investor has invested Rs 1 Lakh in the ELSS plan. In the next year the scheme declares a dividend and the investor is entitled to a dividend of Rs 20,000. This dividend is re-invested on behalf of the investor and he gets additional units of the scheme. The investor can claim income tax deduction for this Rs 20,000 from his taxable income as this investment of Rs 20,000 is treated as fresh investment.

Systematic Investment Plan (SIP)

The process of investing a fixed amount on a regular basis (daily, weekly, monthly) in an ELSS mutual fund scheme is known as Systematic Investment Plan or SIP in short. All ELSS schemes come with the SIP option and investors can start with an investment of as low of Rs 500. The minimum SIP investment amount may differ among different mutual fund schemes.

Regular investment through an SIP helps out the investor to tide over the sharp market fluctuations and volatile movement in the prices of shares. SIP averages out the buying price of units over a period of time.

In an SIP, more units are purchased when the market prices are down and fewer units are purchased at the peak times when the prices are high.
Since SIP investments are regular investments, they inculcate the habit of savings in the investors and result in wealth creation in the long term.
Investing through SIP is ideal for salaried people. They can make regular investment through bank ECS facility.

Charges in a Mutual Fund

There are 3 types of charges in an ELSS Plan:

Entry Load: This is the charge levied by the mutual fund at the time of investment. For example if the entry load is 2.25% and the investor has invested Rs 100, the Rs 2.25 will go towards entry load charges and the remaining Rs 97.75 is invested by the mutual fund on behalf of the investor. If the NAV on that day is Rs 10, then the investor will get 97.75/10 = 9.775 units in his account.

From 1^st August 2009, Securities Exchange Board of India (SEBI) has abolished the entry load for mutual funds. So now all ELSS plans are free of entry load charges. This effectively means that if the investor invests Rs 100, the full Rs 100 will be invested without deduction of any entry load charge.

Fund Management Charges: This is the recurring charge levied by the mutual fund. This charge is for the day to day expenses of the mutual fund. The maximum permissible by SEBI is 2.5% and the industry average is around 2.25%. This charge is collected by the mutual fund by cancelling equivalent units from the investors account.

Exit Load: This charge is levied by mutual funds when the investor sells the units. In ELSS plans there is no exit load.