ELSS Lock-in Period: How Does the 3-Year Lock-in Period Work?

• ELSS investments have a mandatory three-year lock-in period, shorter than other tax-saving options.
• The three-year lock-in is applicable to each ELSS unit bought.
• After the lock-in period, you can redeem units fully or partially, switch between schemes, or stay invested.
• ELSS qualifies for a tax deduction of up to ₹1.5 lakhs under Section 123 if the old tax regime is chosen.
• Capital gains up to ₹1.25 lakhs are tax-free, and excess gains are taxed at flat 12.5%.
• The lock-in encourages disciplined, long-term investing and helps investors stay focused despite short-term market volatility.

ELSS (Equity Linked Saving Scheme) is a popular mutual fund that offers tax benefits under Section 80C of the Income Tax Act, allowing investors to claim deductions of up to Rs. 1.5 lakh on investments in this fund. This 80C deduction (now called Section 123) is available only under the old tax regime. It does not apply if you have opted for the new tax regime.

Like most investments under this section, ELSS funds too comes with mandatory lock-in periods - of three years. With this guide, we will explore the intricacies of the ELSS lock-in period. But first, let us understand what it is.

Lock-in periods are periods during which an investment cannot be sold or redeemed under SEBI rules; this time frame can range from a few months to a few years. In the case of ELSS funds, the lock-in period is of three years. Significantly, this lock-in period is shorter than that of other tax-saving options under section 80C, as shown below:

• ELSS funds: Three years
• Fixed deposits: Five years
• Public Provident Fund (PPF): 15 years
• National Pension Scheme (NPS): Until investor turns 60 years
• National Savings Certificate (NSC): Five years

The ELSS lock-in period encourages participants to keep long-term investment horizons, while helping fund managers to manage the fund's portfolio more efficiently without having to worry about frequent redemptions.

As an investor, you buy units of ELSS funds. The lock-in period applies to the units you purchase within the ELSS funds, not the entire fund itself. Once the three-year lock-in period is over, you have the option to withdraw or reinvest. Here are two ways to invest in an ELSS fund: lump sum investment, and SIP investment.

• The lock-in period starts from the date of investment.
• During the three-year lock-in period, no redemption of units or withdrawal of the invested amount is allowed.
• After the completion of the lock-in period, investors gain the freedom to redeem the units partially or in full.

Example (updated): Suppose Riya invests a lump sum of Rs. 2.4 lakh in an ELSS fund on 15 July 2023, when the NAV is Rs. 120, giving her 2,000 units. Her three-year lock-in period runs until 15 July 2026, after which she is free to redeem the units - either fully or in parts - and any gains realised at that point are taxed as per the applicable LTCG rules.

Also Read: How to Select The Best ELSS Mutual Fund

Each SIP instalment in an ELSS fund is treated as a fresh, independent investment with its own three-year lock-in. For example, if you start a monthly SIP in January, that January instalment gets locked in until January three years later. The February instalment gets locked in separately until February three years later, and so on for every subsequent instalment.

Key insight: This means a 12-month SIP investor does not become fully liquid after just three years. Since the last instalment (say, the one made in December of the first year) is locked in until December three years later, the investor cannot fully redeem the entire 12-month SIP corpus until roughly 4 years after starting the SIP. This is one of the most widely misunderstood aspects of ELSS SIP investing.

• Each SIP instalment has its own lock-in period starting from its respective investment date.
• Redemption restrictions apply to each SIP instalment during its lock-in period, prohibiting early withdrawals.
• As each SIP instalment completes its three-year lock-in period, investors can redeem the investment associated with that unit.

Once the lock-in period for a given unit or instalment ends, the fund does not automatically redeem itself. The investment simply stays put and continues to remain invested until the investor takes action. At this point, the investor can choose to redeem the units (fully or partially), switch to another scheme, or simply continue holding the investment for long-term growth.

If the investor chooses to redeem, long-term capital gains tax (LTCG) at 12.5% applies on gains above ₹1.25 lakh in a financial year, as per the current tax rules.

The benefits of the three-year lock-in

ELSS funds are widely regarded as one of the best investment options for claiming tax benefits under Section 80C. The three-year lock-in period encourages long-term wealth creation and discipline. Here are some benefits of investing in ELSS mutual fund on account of the lock-in period:

Encourages patience: The lock-in period prompts investors to adopt a long-term investment horizon. This encourages staying invested for a significant period, which can potentially lead to higher returns.

Creates wealth: Equity investments tend to perform better over the long term. By investing in ELSS funds and staying committed to the lock-in period, investors have better potential of wealth creation.

Tax benefits: ELSS funds provide tax benefits under Section 80C (now Section 123) of the Income Tax Act (available only under the old tax regime). Investments of up to Rs. 1.5 lakh in ELSS funds are eligible for a deduction. The excess investments over Rs 1.5 lakh do not qualify for deduction. It is important to note that the gains above ₹1.25 lakh realised upon redemption after the lock-in period will attract long-term capital gains tax at the rate of 12.5% (as per the latest Budget update).

Skirts volatility: The lock-in period prevents investors from engaging in impulsive trading decisions that can get triggered by short-term market volatility. Lock-in promotes a disciplined investment approach and discourages frequent buying and selling of fund units.

What to do when the ELSS 3-year lock-in period ends?

The lock-in period for ELSS funds lasts for 3 years from the date of your investment. To find out when it ends, simply add 3 years to the date you invested. If you invest through SIP, consider each installment as a separate investment with its own lock-in period. Once the lock-in period is over, you have some options. First, check how well your ELSS funds have performed and if they have grown nicely. If they show profitable growth, you can choose to keep your money invested even after the 3 years. Alternatively, you can redeem your earnings and the fund, and also enjoy tax benefits.

What happens to ELSS after 3 years?

ELSS funds come with a mandatory lock-in period of three years. Once this lock-in period ends for a particular installment or lump sum investment, the ELSS transforms into a fully liquid and open-ended equity-oriented investment scheme.

Are ELSS returns exempt from taxes after 3 years?

During the three-year lock-in period of ELSS funds, short-term financial gains cannot be realized. Only long-term capital gains can be achieved. Long-term capital gains up to ₹1.25 lakh per year are tax-free, while gains exceeding this amount are subject to a 12.5% LTCG (updated as per the latest Budget; the earlier rate was 10% with a ₹1 lakh exemption).

ELSS Under the New Tax Regime - Is the 80C Benefit Still Available?

Under the new tax regime, the Section 80C (now called Section 123) deduction is not available, which means ELSS loses its primary tax advantage for investors who opt for this regime.

That said, ELSS can still be useful even under the new regime - it remains a well-diversified, professionally managed equity fund with a lock-in of just three years, which is considerably shorter than PPF (15 years) or NPS (till age 60). Rather than positioning it purely as a tax-saver, investors under the new regime may consider ELSS as a straightforward wealth-creation vehicle.

Also Read: SIP or Lumpsum : Which Is Better For ELSS Investment?

Navigating the lock-in period

During the lock-in period, investors must consider certain factors to save themselves from the probable risks associated with the ELSS funds, and take steps to shield themselves. Let us take a look at some of these measures:

Ensuring liquidity and access to funds: It is important to ensure sufficient liquidity for any unforeseen financial needs during the lock-in period. Investors should plan their investments accordingly and maintain an emergency fund outside the ELSS funds.

Preparing for changes in crises: In case of changes in financial goals or emergencies, investors cannot access their ELSS funds before the completion of the lock-in period. Hence, it is essential to align investment objectives and risk tolerance with the lock-in period.

Strategies for managing the lock-in period effectively: Investors can adopt strategies like systematic investment plans (SIPs) to stagger their investments over multiple financial years. This approach ensures that funds become eligible for redemption after the completion of the respective three-year lock-in periods.

Tracking fund performance evaluation during lock-in period: While investors cannot redeem their ELSS fund units during the lock-in period, it is still essential to monitor the performance of the scheme. This evaluation helps in making informed decisions about continuing with the fund or switching to a different scheme after the lock-in period.

Exceptions and considerations

Given below are two considerations to take note of:

Applicable exemptions or exceptions to the lock-in period: In certain cases, such as the demise of the investor or in situations of critical illness or disability, an exception may be made to the lock-in period.

Impact of switch options and dividend reinvestment: Switching between different schemes within the same fund or opting for dividend reinvestment does not affect the lock-in period. The three-year lock-in is still applicable to the initial investment.

• Step 1: Log in to the ABCD app (or your fund house's platform) and navigate to your ELSS holdings.
• Step 2: Select the units that have completed their three-year lock-in and choose 'Redeem'.
• Step 3: Alternatively, redeem via registered RTAs such as CAMS or KFintech using your folio number and PAN.
• Step 4: Confirm the redemption amount/units and submit the request; proceeds are credited to your registered bank account.

Note: Redemption of ELSS units after the lock-in period triggers capital gains, which are subject to LTCG tax rules. Investors should retain redemption statements and capital gains records for accurate ITR filing.

Understanding the three-year lock-in period is vital for investors considering ELSS funds as a tax-saving and wealth-creation avenue. The lock-in period encourages a long-term investment approach, allowing investors to potentially benefit from market growth and enjoy tax benefits. While the lock-in period restricts immediate access to funds, it promotes financial discipline and discourages hasty investment decisions based on short-term market volatility. It pays to be aware of the dos and don'ts to navigate the lock-in period, which can be relaxed under specific conditions, though it is advisable to consult with a financial advisor for better insight. By understanding and navigating the lock-in period effectively, investors can maximise the advantages offered by ELSS funds and align their investment strategy with their financial goals. And as always, seek guidance from a financial expert.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.

Also Read: What Are Tax Implications On ELSS?