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What is Lock in Period? Lock in period explained for tax saving investment options.

lock in period
lock in period

Introduction

The period during which investments are locked in is called lockin period or lockup period. Investors cannot sell their investments during this period of time. Lock-in period is common to hedge funds, IPOs of private equity, startups and few mutual funds. In mutual funds, ELSS funds (tax saver funds) are the only open ended funds with a lock in period. In this article, we have covered in detail about lock in period, why it is important, and the steps to be taken after the lockin period ends.

What is a lock in period?

Lock in period is the time period during which investors are restricted to redeem or sell their investments. During a lock in period, investors can’t sell their investments. However, once the lock in period ends, investors are free to sell their investments.

Lock in periods is normal when a private equity firm offers its initial public stock. The management is restricted to sell their investments right after an IPO. Hedge funds and startups also use the lock in period. Hedge funds use it to maintain portfolio stability. At the same time, startups use it to retain cash.

Lock in period for mutual fund investments is not uncommon. All closed ended mutual funds have a lock-in period. Open ended mutual funds do not have a lock in period. However, there is an exception, Equity Linked Savings Scheme (ELSS) funds have a lock in period of 3 years. In other words, investors cannot sell their investments during this period of time. Once this period ends, investors can stay invested in the fund for as long as the fund exists or choose to sell their mutual fund units.

Open ended mutual do not have a lock in period. However, they charge an exit load if the investors exit within a year.

Why is lock in period important?

Lock in period is important for investors to reap benefits from investing in equities. Most of the investors lack the knowledge and react to small market movements. Having a lock in period in place will help investors stick to the investment for some time and reap benefits from long term investing.

Mutual fund investments have a lock in periods to induce stability in the fund. With excessive selling, the redemptions might increase, which can cause liquidity issues for the fund. Hence lock in period will help in preserving liquidity. A lock in period will restrict investors from selling their units and keep the fund’s assets stable. They do this in the interest of investors. So that investors can reap significant benefits from their equity investments. Hence by maintaining market stability, mutual funds try to protect the wealth of investors.

Lock in period in mutual funds

Equity Funds

Under equity mutual funds, Equity Linked Savings Scheme is the only type of fund that has a lock in period. Equity Linked Savings Scheme (ELSS) has a three year lock in period. Investments in ELSS funds qualify for tax exemption under Section 80C of the Income Tax Act. The limit for tax exemption is INR 1,50,000 per annum. However, the returns from ELSS funds are taxable. They are subject to Short Term Capital Gains Tax (STCG) of 15% if the holding period is less than one year. And Long Term Capital Gains Tax (LTCG) of 10% for capital gains above INR 1,00,000 if the holding is above one year.

Following are the top ELSS Mutual Funds:

Debt Funds

Debt Mutual Funds have 16 types of funds under the category. None of these 16 funds has a lock in period.

Hybrid Funds

Similar to other types of mutual funds, hybrid funds also do not have any lock in period

What to do after the expiry of lock in period?

Once the lock in period ends, the investors shouldn’t straight away redeem their investments. They should review the performance of the investment and then decide whether to redeem or not. In the case of ELSS mutual funds, investors must review their fund performance.

Review the performance of the ELSS fund

ELSS funds do not just help in saving tax. They serve the dual purpose of tax saving and long term capital appreciation. Most investors use ELSS funds just as a vehicle to save tax. Once the three year lock in period ends, they redeem this investment to invest in a new ELSS fund. They do so to save tax. However, this restricts the benefits of investors.

ELSS funds invest in equities. They are just multi cap funds with diversified portfolios managed by an experienced fund manager. The fund manager charges a fee for the services. It is suggested that investors stay invested in these funds for at least a period of 5-7 years to reap significant benefits from their ELSS investments. A period of 3 years is not enough time for equities to grow to their maximum. However, it is recommended that investors perform a fund review after a period of 3 years.

Decide to stay invested or not

After a period of 3 years, investors can review their investment in the ELSS fund. For this, investors must align their goals with the fund’s performance.

If the fund is growing and in line with the investor’s financial goals, then the investor can continue to stay invested in the fund. However, if the fund’s performance is not in line with the investor’s goal, it is better to redeem this investment and invest in a new ELSS fund.

Redeem the investment

Investors should not base lock in period as their investment tenure. A lock in period is imposed in the interest of investors and to preserve liquidity and maintain fund stability. ELSS funds’ lock in period expires after three years. Investors are advised to redeem their investments only if they genuinely require money. In case of medical emergencies or uncertainties, redeeming investments is justified.

Redemption of investments can also be done when one is nearing a financial goal, or the fund’s performance is not in line with the goal. Else, investors can stay invested to reap significant benefits from equity investing.

Lock in period of other tax saving investment schemes

ELSS funds are tax saver funds. They qualify for tax saving under Section 80C of the Income Tax Act. Few of the other tax saving investments with a lock-in period are Tax Saving FD, PPF, NPS, and NSC.

Tax saving FD

A tax saving FD is a fixed deposit scheme that qualifies for tax exemption under Section 80C of the Income Tax Act. The main purpose of tax saving FDs is to encourage long term savings along with tax benefits. Also, FDs come with a lock in period of 5 years. These investments are low risk investments. Hence, they are ideal for investors who prefer fixed income from their investments.

Investment in tax saving FDs qualifies for tax exemption up to INR 1,50,000. However, the interest earned is taxable as per the individual’s income tax slab rate. Additionally, there is a TDS of 10% on interest income above INR 40,000 (INR 50,000 in case of senior citizens).

Public Provident Fund (PPF)

Public Provident Fund (PPF) is one of the popular investment schemes. The Government of India backs the Public Provident Fund. This scheme is a good option for both retirement planning and tax savings. However, the Public Provident Fund has a lock in period of 15 years. Also, this is a low risk investment option. PPF offers guaranteed returns. The current interest rate is 7.10%. Therefore, the scheme is ideal for low risk investors. It is also ideal for investors seeking guaranteed income.

Additionally, the scheme also offers tax benefits. In other words, PPF investments up to INR 1,50,000 per annum qualify for tax exemption under Section 80C of the Income Tax Act. The minimum investment into the scheme is INR 500 per annum, and the maximum is INR 1,50,000. PPF allows only 12 instalments in a year. 

National Pension Scheme (NPS)

The National Pension Scheme is a pension plus investment scheme. Also, it is a voluntary retirement plan. The Government of India backs the NPS. NPS investments are invested across different asset classes like equity and debt. The investor has an option to pick the type of investment they wish to invest in. Therefore, NPS investments are market linked. Hence they do not guarantee returns.

The National Pension Scheme has a lock in period until the investor reaches the age of 60 years. The scheme encourages investors to save for their retirement. NPS contributions qualify for tax exemption under Section 80C and 80CCD of the Income Tax Act. Under Section 80C, investors can claim up to INR 1,50,000. Additionally, under Section 80CCD, they can claim INR 50,000.

NPS is suitable for investors looking for retirement savings and is willing to undertake some risk. Historically, the scheme has given returns around 9% to 12% per annum. Furthermore, upon maturity, 60% of the corpus can be withdrawn as a lump sum, and it doesn’t attract any tax. The scheme prescribes at least 40% of the total corpus to be invested in an annuity.

National Savings Certificate (NSC)

National Savings Certificate (NSC) encourages small and medium savings. NSC is a fixed income scheme. The Government of India backs the scheme. Hence, the risk is low. The scheme offers guaranteed returns. Therefore, NSC suits small investors who wish to invest small amounts and seek guaranteed returns.

The minimum investment for NSC is INR 100, and there is no maximum limit. However, investments up to INR 1,50,000 per annum qualify for tax exemption under Section 80C of the Income Tax Act. Also, there is no TDS for NSC investment payouts.  However, the returns are taxable as per the investor’s income tax slab rates. 

NSC has a lock in period of 5 years. The current interest rate is 6.8%. The interest earned during the tenure of the investment is automatically reinvested into the scheme. The interest also qualifies for tax exemption.

Conclusion

A lockup period doesn’t just impose restrictions on selling investments. It also provides an opportunity for investors to grow their investments. A lock in period doesn’t define the tenure of investment. It is a mere restriction put by the AMC or company to preserve liquidity and maintain stability in the market.

It is not mandatory to redeem investment from ELSS funds once the lock in period ends. However, monitoring an investment once the lock in period ends is necessary. Investors can redeem their investments only when their fund isn’t performing in line with their goals. Or, when they need money for any emergency. Investors shouldn’t redeem their investments after the lock in to invest in a new ELSS fund to save tax.

It is advised to stay invested in ELSS funds for a period of 5-7 years to reap significant benefits from equities.

Published on September 1, 2020