How to save on capital gains tax: Top investment strategies

ELSS investments are popular among investors as they diversify the portfolio, build a corpus, and lead to long-term capital appreciation. They are mutual fund investments made primarily in equity markets. Because of their high returns and tax savings, ELSS investments are a highly profitable avenue for long-term investors.

One of the biggest reasons people choose ELSS funds over others is the tax deduction benefit under Section 80C of the Income Tax Act.

This guide explains ELSS mutual funds, the tax benefits of such investments, and practical advice on investing in them. It will help investors choose to ensure financial growth and tax relief.

What is ELSS Mutual Funds: Meaning and Definition

ELSS stands for Equity-Linked Savings Schemes. This category refers to equity-oriented mutual fund investments, better suited for long-term investors as they offer higher returns than debt instruments. However, as ELSS is market-linked, returns from these schemes will vary.

Some of the most prominent features of ELSS investments are as follows:

The lock-in period of ELSS mutual funds is three years, the shortest among all tax-saving options under Section 80C.
ELSS mutual funds are a high-risk category because of the equity exposure.
Investment is made in equity and equity-related funds (80% of the corpus).
ELSS mutual fund schemes spread the money invested across large, mid, and small-cap sectors.
ELSS receives revenue from its investments as long-term capital gains (LTCG). As per Budget 2024, the LTCG tax rate has been raised from 10% to 12.5%, and the LTCG exemption threshold has been enhanced from ₹1 lakh to ₹1.25 lakh.

ELSS — Wealth Creation and Tax Saving

The motive behind investing in ELSS mutual funds is to generate wealth and save taxes in the long run. Let us look at this double benefit offered by ELSS investments:

1. Wealth Creation

ELSS mutual funds invest more than 80% of their corpus in equities. The returns on ELSS are directly associated with the movements made in the market and may not be as predictable as fixed returns from traditional savings schemes. ELSS works well for risk-seeking investors looking to generate wealth in the long run.

2. Tax Benefits

Under Section 80C of the Income Tax Act, an investment in ELSS qualifies for a deduction of ₹1.5 lakh. Important points related to the 80C benefit are as follows:

The tax savings of ₹1.5 lakh are added to other Section 80C investments, such as the Public Provident Fund (PPF), National Savings Certificates (NSC), and even life insurance premiums.
The ELSS SIP installment locks in for three years, as opposed to any other investment under Section 80C—PPF for 15 years and NSC for five years. This helps in gradual wealth building, as money appreciates over time due to compounding. It also means that the risk is minimized.
The returns on ELSS are taxed as LTCG. The LTCG exemption amount has been increased from ₹1 lakh to ₹1.25 lakh, and the LTCG tax rate has been revised from 10% to 12.5%.
ELSS offers wealth creation and tax-saving capabilities that attract salaried employees and self-employed who wish to optimize their tax savings by creating a substantial corpus to meet future monetary requirements.

How Do ELSS Funds Work?

ELSS mutual funds are diversified equity funds. They invest in most of the equity shares of listed public companies, cutting across large-cap, mid-cap, and small-cap segments and different industries. With this balanced mix, investors get a wide range of market exposure.

Here is how ELSS funds work according to SEBI guidelines:

ELSS invests at least 80 percent in stocks following the Equity Linked Saving Scheme, 2005, notified by the Ministry of Finance.
It has a lock-in period of 3 years, which is the shortest among all other tax-saving options.
Available exemptions under Sec 80C of the Income Tax Act are to the extent of ₹1,50,000.

How to Choose Mutual Funds?

There is a strategic way of investing in ELSS mutual funds. ELSS is just like any other mutual fund with 60% in equities. Here are some tips that will help investors choose the correct mutual fund:

1. Check the Performance of the Fund

Individuals should begin by analysing the fund’s historical performance over different periods, namely three, five, and ten years. They should check that the returns consistently outperform the benchmark or peers.

2. Analyse the Portfolio of the Fund

One should try to ascertain the composition of the portfolio in the fund. A diversified portfolio with different sectors decreases the level of risk. The equity allocation in a fund should complement the risk appetite.

3. Consider Expense Ratio

The expense ratio is the fee applied by a fund manager, and it directly affects returns. Therefore, investors must choose funds with low expense ratios to increase overall net returns.

They must choose ELSS funds with a direct plan to avoid the distributor commission. Besides, it is important to appreciate the exit strategy, as ELSS withdrawal is permitted only after three years of lock-in.

4. Assess the Expertise of the Fund Manager

Experience and a track record of fund management are essential for managing the risks in the marketplace and achieving the highest returns. Therefore, investors must select experienced professionals with positive track records to manage funds.

5. Consider Investment Horizon

Assess the risk appetite before investing and choose funds that align with risk tolerance levels. When investing in an ELSS scheme, the three-year lock-in period applies. In other words, one has to keep money invested for more than five years or seven years during the cyclical growth phases of the market to capitalise on the cycles.

How to Invest in an ELSS Fund?

There are several ways in which one can invest in ELSS mutual funds, including:

Online Mutual Fund Investment Platforms: Popular online mutual fund investment platforms simplify access to ELSS investments and provide it digitally.
Demat Account: People can use their demat account to invest in ELSS through the stock exchange.
Directly with Mutual Fund Houses: People can invest directly with mutual fund houses or through registrars’ services.
Agents: Financial advisers or agents guide the investors on the right ELSS mutual fund investment.

Why Invest in ELSS Tax-Saving Mutual Funds?

The primary purpose of investing in ELSS mutual funds is to save taxes. Let us understand this with an example:

For example, an investor invests in ELSS and Non-ELSS funds:

Investment amount in both ELSS and Non-ELSS funds: ₹20,00,000
Both funds offer an annual return of 12%
Holding period: more than 3 years for both investments.
Tax on Long-Term Capital Gains: 10% on gains exceeding ₹1.25 lakh
ELSS allows tax deduction under Section 80C up to ₹1,50,000

Calculating Returns and Tax Implications

1. ELSS Funds

Annual Return: ₹20,00,000 × 12% = ₹2,40,000
Total Long-Term Capital Gains (LTCG) after 3 years will be ₹2,40,000 × 3 = ₹7,20,000.
LTCG Exemption: ₹1,25,000 is exempt from tax
Taxable LTCG: ₹7,20,000 – ₹1,25,000 = ₹5,95,000.
Tax Deduction Benefit (under Section 80C): Eligible to reduce taxable income by up to ₹1,50,000

2. Non-ELSS Mutual Fund

Annual Return: ₹20,00,000 × 12% = ₹2,40,000
Total Long-Term Capital Gains (LTCG) after 3 years will be ₹2,40,000 × 3 = ₹7,20,000.
Tax Deduction Benefit under Section 80C: Not eligible for Non-ELSS type

Here’s why investing in ELSS mutual funds can be beneficial:

1. Diversification

ELSS funds invest in various small-cap, mid-cap, and large-cap companies from many sectors. This helps the investor diversify their portfolio to the best possible extent, reduce potential risks to a minimum, and increase return.

2. Low Minimum Investment

Most ELSS schemes have minimum investments of just ₹500. This makes it extremely easy for beginner investors who do not have a sizeable amount of capital in hand.

3. Regular Small Investments

Under a SIP, small amounts can be invested at regular intervals. In addition to making investment management easier, SIPs provide rupee cost averaging, reducing the unexpected impact of market-related fluctuations.

4. No Upper Limit

The best part of ELSS funds is that the investments are not capped; though tax benefit under Section 80C is limited to ₹1.5 lakh a year, the potential investor can stay invested beyond three years. After this, they are free to leave, ensuring their growth prospects.

Conclusion

ELSS mutual funds are a sound financial tool that combines the possibilities of wealth generation with the tax benefits under Section 80C of the Income Tax Act. Investing in these equity-driven schemes can help one achieve long-term growth and decrease tax liabilities.

Being market-linked, investment in this scheme should be made after considering fund performance, risk factors, and personal financial goals. Based on this strategy and long-term approach, ELSS mutual funds can be a good constituent of the investment portfolio.

FAQs

1. Is the ELSS fund risk-free?

The ELSS fund is a risky investment because it mainly invests in equity instruments. A large portion of equity investments is affected by market volatility. However, the fund makes long-term investments and may also bring higher returns.

2. How soon can I withdraw the investment in ELSS?

You can withdraw your investment after three years of the lock-in period. If you have made a one-time lump sum investment, you can withdraw your total amount immediately. In the case of SIP, each instalment will have a three-year lock-in period.

3. Who should invest in ELSS funds?

ELSS funds are ideal for salaried workers and first-time investors. It is an excellent choice for people seeking tax-saving options incorporating possible long-term growth. It is also good for high-risk-tolerance investors.

4. Is ELSS safe for conservative investors?

ELSS is quite risky, as it presents market risk due to its equity exposure. Therefore, it cannot be recommended for very conservative investors. It’s best suited for those with a moderate to high-risk appetite and a long-term investment horizon, as it provides excellent opportunities for creating wealth and saving taxes.

Disclaimer: The information provided is for informational purposes only. PowerUp is not responsible for any omissions, errors, or outcomes related to using this information.