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Equity Linked Savings scheme (ELSS)While tax planning may seem to be a difficult process, Mutual Funds offer you a simple way to get tax benefits, while aiming to make the most of the potential of the equity markets.An Equity Linked Savings Scheme (ELSS) is an open-ended Equity Mutual Fund that doesnt just help you save tax, but also gives you an opportunity to grow your money. It qualifies for tax exemptions under section (u/s) 80C of the Indian Income Tax Act.Why should you invest in an ELSS?Along with the tax deductions, an ELSS offers you the following benefits:An opportunity to grow your money by investing in the equity market.Long-term capital gains from these funds are tax free in your hands.The lock-in period is only 3 years. This type of mutual fund has a lock in period of 3 years from the date of investment. This means if you start a Systematic Investment Plan in an ELSS, then each of your investments will be locked in for 3 years from the respective investment date. Investors can exit ELSS by selling it after 3 years.You can also opt for a Dividend Payout option, thereby realizing some potential gain during the lock-in period.#You can invest through a Systematic Investment Plan and bring discipline to your tax planningSimilar to other equity funds, ELSS funds have both dividend and growth options. Investors get a lump sum on the expiry of 3 years in growth schemes.On the other hand, in a dividend scheme, investors get a regular dividend income, whenever dividend is declared by the fund, even during the lock-in period.For tax purposes, returns from an ELSS scheme are tax free. You can claim upto Rs. 1 lakh of your ELSS investment as a deduction from your gross total income in a financial year under Sec 80C of the Income Tax Act.Key points to rememberA Equity linked savings schemes is a type of mutual fund with 3 years lock in period and tax benefits attached,B - There are three types of options in ELSS, dividend option growth option and dividend reinvestment option.C Tax benefits on investment in ELSS may soon be phased out with the introduction of direct tax code.D Investors can opt for systematic investment plan. Minimum investment required in SIP is Rs 500. An investment through SIP has a disadvantage as every monthly investment carries a lock in period.E - If an investor chooses dividend reinvestment plan the dividend reinvested is considered as a fresh purchase and has a lock in period of 3 years from the date of purchase so the dividend reinvested is further locked for a period of 3 years.F ELSS has the potential to give higher returns as these funds invest in equity market which have given an average return of 15 years in a long term scenario. Returns in ELSS also fluctuate depending upon the stock selection decision of the fund manager.G SIP helps in averaging out the cost of investors, however if the investor backs out from SIP when the markets are falling he wont be able to average out his cost.# However, it must be noted that any dividend payment will be from the NAV of the Scheme and therefore the NAV of the scheme will fall to the extent of dividend payment. Also dividend payment is subject to availability of distributable surplus and approval from Trustees.

Criterias to chose ELSS a) AUM Asset under management is the amount of money the fund is managing. Higher AUM implies that the fund has many investors and has a good reputation.

b) Past performance If the fund is performing well in the past, it is expected that the fund will keep performing well in the future. Generally we look at the past 3 yrs 5 yrs and 10 yrs return of the fund.

c) Sharpe ratio Sharpe ratio is used to calculate risk factor of the funds portfolio. Sharpe ratio of the fund should be near 1.

Features of ELSS and other Tax Saving instruments u/s 80C of Income Tax Act, 1961ParticularsPPFNSCELSS

Tenure15 years6 years3 years

Returns8.70 % *(Compounded Annually) 8.50 to 8.80 % *(Compounded half-yearly) Returns / Dividends are Market linked and not assured

Minimum InvestmentRs.500Rs.100Rs.500

Maximum InvestmentRs.150,000No limit^No limit^

Amount eligible for deduction u/s 80C Rs.150,000Rs.150,000Rs.150,000

Taxation for interestTax freeTaxableDividends and capital gain tax free

Safety/ RiskHighest SafetyHighest SafetyHigh Risk

Lock-in Period15 Years - Partial Withdrawal after 6 years is permitted6 Years3 years

Mutual funds Vs ELSSa. Tax Free: - There is no ceiling for investments in ELSS however investments in ELSS qualify for tax deductions under sec 80C of the income tax act subject to a maximum of Rs 100000 in a financial year whereas investments under normal mutual fund do not qualify for income tax deductions. Any dividend received or long term capital gain earned by the investor is tax free. Long term capital gain arises on selling units of mutual fund after 1 year of purchase. Since there is a lock in period of 3 years every investor will realize long term capital gain/loss on selling their holdings

b. Lock In: - ELSS has a lock in period of 3 years unlike other kinds of mutual funds.

Will you get assured returns?

Since these are essentially diversified mutual funds, there is no guarantee on returns. The ELSS category has given an average return of 2.95% in the past five years. The best performing fund increased an investment of Rs 10,000 to Rs 16,519 during this period, but the worst performing scheme reduced it to Rs 5,991.

In the past three years, the average return has been 6.82%, while the best performing fund has given 13.5%. So, apart from the performance of the broader market, your returns are dependent on the fund manager's ability to pick the right stocks. This also means you must select the fund after proper research. Instead of picking a fund with high, but volatile, returns, choose one with a stable performance record.

What's the lock-in period?

The lock-in period is only three years, the shortest among all tax-saving options under Section 80C. You cannot redeem or switch to another option during this period. In the case of SIPs, each instalment is treated as a separate investment and will have a three-year lock-in period. So, if you started investing in an ELSS fund in April 2010, you can redeem the units bought in the first instalment only in April this year.

Those bought in May 2010 will be open for redemption only in May. The lock-in stipulation does not mean that the investor must compulsorily redeem the funds after three years. Unlike Ulips and pension plans, there is no maturity date of an ELSS fund. If you want, you can remain invested for a longer period. 4) Dividend, growth or reinvestment?

The dividend is only a profit-booking exercise since a fund's NAV reduces by the amount the investor receives as dividend. In the growth option, the amount remains invested for the entire tenure.

The dividend option provides a periodic income to the investor, though there is no obligation on the part of the mutual fund to declare a dividend or maintain its payout ratio year after year. The growth option has the potential to generate higher returns. Your choice should depend on your needs and risk appetite. Avoid the dividend reinvestment option because you will find it difficult to exit the fund completely. There will always be some units that have not completed the lock-in period.

How should you invest?

Unlike regular equity schemes, the ELSS funds have a lower investment threshold of Rs 500. You can invest a large amount at one go, but the best way to invest in equity-oriented instruments is through regular monthly driblets called SIPs.

For instance, if you have Rs 30,000 to invest in ELSS funds this year, split them into three instalments between now and 31 March. This will curtail the risk significantly by averaging out your cost of purchase. To start an SIP, submit post-dated cheques or give an ECS mandate to your bank. The money will be automatically transferred to your mutual fund every month.

ELSS as Tax saverEquity-linked saving schemes (ELSS) have the shortest lock-in period of three years among all the tax-saving options under Section 80C. However, this should not be the most important reason for investing in this avenue. Being equity funds, these schemes can generate good returns for investors over the long term. In the past five years, this category has created wealth for investors with average returns of 17.5 per cent.However, this potential to earn high returns comes with a higher risk. There is no guarantee that your investment will generate positive returns after the 3-year lock-in period. The category has generated an average return of 2 per cent in the past three years. Even the best performing funds have churned out disappointing returns. The returns will naturally mirror the performance of the stock markets. Therefore, only investors who have the stomach for a roller-coaster ride should consider this option.Should investors avoid ELSS now, especially since the stock market is close to its all-time high? Not really, because the stock market has returned to the previous high after a 6-year gap and, therefore, is not overvalued at all. "Since the stock market is reasonably valued now, ELSS should generate good returns for investors who can remain invested for 5-7 years," says Gajendra Kothari, managing director and CEO, Etica Wealth Management.

Though the large-cap Sensex and Nifty are at higher levels, the mid-cap and small-cap indices are at much lower levels. This means there is enough value in midcap stocks, which should help the fund managers do well in the coming years. Selecting the right scheme is crucial since there is significant variation in the returns of different schemes.

Though past performance is an important parameter, also take into account the track record of the fund house and fund manager. Once you select a scheme, decide whether you want to go for the dividend or growth option. There is no difference in the tax treatment of the two options. The decision should be based on the cash-flow requirements of the investor. If you opt for the dividend option of the fund, you might get some portion of the money back within 1-2 months. Dividends from mutual funds are tax-free so there is no tax liability as well. Avoid the dividend reinvestment option for ELSS schemes because the lock-in period will prevent you from exiting fully.

Though the ELSS funds invest in equities, they are different from other open-ended diversified equity funds. Due to the lock-in period, the ELSS fund manager does not have to worry about redemption pressure from investors. This gives him the freedom to invest in shares as per his conviction and hold them for longer periods.

In the past few years, the ELSS category has consistently outperformed the large and midcap sub-category of diversified equity funds (see graphic).

ELSS funds offer tremendous flexibility to investors. As mentioned earlier, the 3-year lock-in period is the shortest. Since there is no tax on gains from equity funds after a year, an investor can safely recycle his investments every three years and claim tax benefits on the reinvested amount.

Young taxpayers, who have taken huge loans and don't have enough surplus to save tax, will find these schemes very useful. If you can help it, don't exit the scheme after three years just because lock-in period is over. Studies show that equities give better returns in the long term. The minimum investment is also very low.

Though regular equity mutual funds have a minimum investment of Rs 5,000, you can put in as little as Rs 500 in an ELSS scheme. Unlike a Ulip, pension plan or an insurance policy, there is no compulsion to continue investments in subsequent years. Since ELSS funds are a high-risk investment and their NAVs are volatile, you need to stagger your investment over a period of time instead of going for a lump-sum investment at the end of the financial year. This is more important at this juncture when the benchmark indices are trading close to their all-time high levels.

Your best option is to take the SIP route. This may not be possible now because you have less than three months before the 31 March deadline. At best, you can split the investment into three tranches. Before you take the plunge, remember that your investment should be guided by your overall asset allocation. If your exposure to equities is lower than what you want, go for the ELSS fund. If your portfolio already has too much equity, avoid investing in these funds.

Points to remember while choosing an appropriate ELSSYou must always remember to do thorough research when you invest in an ELSS fund. You must look at the long term performance of the fund before putting your money in it. Also remember to look at the fund details like the fund managers investment approach, portfolio of the fund, the expense ratio of the fund and how volatile the fund has been in the past.Mutual Fund investments are subject to market risks, read all scheme related documents carefully.