Explained: Some common misconceptions about tax-saving mutual funds

Dev Ashish

As another new financial year begins, people will start planning their taxes. And for many, investment made in the ELSS (or Equity Linked Savings Scheme) is their first or initial experience with the stock markets. As part of the Section 80Cs tax exemptions, ELSS gives investors a shot at getting higher returns, shorter lock-ins and, of course, saving taxes.

Now even though I do not advocate saving tax as a goal, the fact is that most people think like that and do not take the correct approach of linking investments to goals.

If you are an ELSS investor, be clear about some misconceptions and misunderstandings regarding the schemes.

Clearing the air

-The lock-in period for ELSS funds is three years. So, if you start an SIP, then does the three-year lock-in end exactly three years from the start date? No. Each SIP instalment in ELSS funds has a three-year lock-in period. Let’s say you start the SIP on 10 April 2020. So your first SIP instalment will be locked-in till 10 April 2023. The second SIP (on 10 May 2020) will be locked-in till 10 May 2023. And so on.

-The tax-saving limit for Section 80C via ELSS (and all other options) is limited to Rs 1.5 lakh. But that doesn’t mean that you cannot invest more than Rs 1.5 lakh in ELSS funds in a given financial year.  But you won’t get any additional tax benefit on it.

-ELSS has a lock-in of three years. But it doesn’t automatically get redeemed after three years. You are free to remain invested even after the completion of the first three years of mandatory lock-in. It’s also not necessary to sell ELSS funds immediately after three years. So, if your fund is doing well, there should be no hurry to exit.

-Some people have this wrong notion that you can only invest lump-sum in ELSS. If you want to fully utilize Rs 1.5 lakh limit of Section 80C using ELSS, then you can start an SIP of Rs 12,500 a month in ELSS funds.

-Since the lock-in is three years, is ELSS suitable only for the short term? Not true at all. ELSS is just a different flavour of pure equity funds. Nothing else. The scheme invests in stocks. And when investing in stocks, you should always have a long time horizon; at least five years, if not more. And as per the past available data, if you remain invested in equity funds for long enough, the probability of loss greatly reduces. And to some extent, the probability of getting inflation-beating returns (that we associate with equity) also increases.

-Many think that they need to keep investing in the same ELSS fund every year (for at least three years) to get a tax deduction in each of those years. Wrong. You are free to pick different ELSS funds or even split your investment across multiple funds.

-All ELSS funds are not the same. Unlike other mutual funds that have clearly defined mandates of the exposure they can have across various market caps, ELSS funds don’t have any such restrictions. These funds have the flexibility to invest anywhere. Some ELSS funds invest heavily in large-caps, while many others have a higher concentration of mid & small-caps. And some always maintain a sort of balanced portfolio. Due to the difference in approach towards portfolio construction, ELSS funds operate with different levels of risk. And hence, you should always try to pick an ELSS fund that suits your risk profile. I also feel that simple index funds (with lock-in) should be offered as tax-saving funds to do away with the need to pick ELSS funds. Investors can then simply pick one Index ELSS fund and invest in it for years.

-Some investors simply pick last year’s best ELSS fund. This way, they end up having a new fund every year. This is unnecessary. At best, limit ELSS exposure to just 1-2 funds in the overall portfolio.

In future, if the whole concept of tax exemptions is done away with, then the utility of ELSS funds will have to be reassessed.

(The writer is the founder of StableInvestor.com)