Tax Saving Investments in India – Pros and Cons
For most salaried people income tax can be a significant part of their annual budget. For some people, tax saving investments, is almost synonymous with tax planning barring few exceptions.
The period from February to March is the time when most people buy or invest in tax savings products as a last resort to reduce their income tax liability. Some people plan and do this in advance, but the real debate is ‘whether these tax saviors are good investments?’
Although we use the term “tax savings” we will also discuss some products or instruments where the income or returns are tax free. For example tax free bonds, tax free dividends, etc. The early bird gets more worm. An early investment starts earning returns sooner and also helps you benefit from the magic of compounding.
Benefits of Tax Saving Investments
There are plenty of tax saving investments to choose from, so one has to look at his or her needs before buying or investing in them. For instance the Income Tax laws in India provide up to Rs.1 lakh of deduction under Sec 80 C for investment in a specified set of product or instruments. For instance there are deductions on life insurance premium, housing loan principal repayment, investment in fixed deposits, investment in tax saving funds, etc.
For example :- Mr. Prasad, a dentist who work for a hospital invested Rs.50,000 in HDFC Tax Saver Fund. This means his taxable income would get reduced by Rs.50,000. Assuming he is in the 20% tax bracket, his tax savings would be roughly Rs.10,000 (20% of Rs.50,000)
[This is a simple illustration where surcharge, cess etc., are not considered. Please consult a tax advisor to get accurate workings]
The benefits of tax saving investments could be one of the following:-
- Reduces taxable income and Saves tax (which is obvious)
- Encouraged people to invest or save for their future
- Provides other benefits such as insurance cover, health cover, housing, etc.
Pitfalls of Tax Saving Investments
Let me clarify here that all tax savings investments are not bad. There are good, bad and neutral ones in this category. Moreover, a tax saving instrument that benefits me may not benefit you in the same way, so a ‘one size fit all’ approach will not work. However, there are some drawbacks that one might potentially face which include
Long Lock in Period
For example Public Provident Fund (PPF) is projected as one Holy Grail which all investors can benefit from. Do you know how long you need to stay invested in PPF?
The lock-in period is 15 years though there is an option to make partial withdrawals from 7th year. So your money is going to be stuck with someone for 7 years and you have no option of redeeming or selling it if you have an emergency need or if you find alternate investment avenues.
What Should You Do?
I’m not saying that all tax savings products are bad but one has to understand the features and implications of the product before investing their hard earned money.
Limit of Rs.1 Lakh in Sec 80 C: No matter how much you plan and invest or make arrangements the total limit in Sec 80 C is only Rs.1 lakh. This requires you to consider other provisions or avenues to save tax. Lets see an illustration to understand better.
For instance Mr.Franklin D’Souza, an architect in Goa took a mediclaim or health insurance policy for himself, wife and children for Rs.16,000. Similarly he also took a health insurance plan for his parents (not senior citizens) for Rs.20,000. He already availed a deduction of Rs.1 lakh on housing loan principal payment under Sec 80 C.
How did Mr. D’Souza benefit?*
- He was able to claim Sec 80 C deduction of 1 lakh for his housing loan payment.
- In addition to the above he could get additional deduction of Rs.30,000 (which consist of Rs.15,000 the limit allowed for self, spouse and children, plus Rs.15,000, the limit allowed for parents)
As tax laws and its interpretation changes readers are advised to consult a professional tax expert before making any decisions
Income from the Tax Saving Product is Taxable
When I used to work for a financial services company I observed customers enquiring about infrastructure bonds issued by institutions such as IDBI, NHAI, etc. These bonds had long lock in periods – for instance it was 6 years for NHAI bonds.
But There was Another Catch
The interest income from these bonds is again taxable. Although the tax on the income earned may not be significant, but it still defeats the strategy of these investors who want to avoid or minimize tax altogether by some way or the other.
Some instruments provide tax deduction or relief from capital gains, but the returns offered would be paltry. For instance NHAI bonds offer 6% interest p.a. which is significantly lower than the inflation (WPI-Wholesale Price Index) and probably offering negative returns after inflation.
The returns post tax would be even lower which means you are actually seeing erosion of income from these investments. However, NHAI bonds provide another benefit which is relief from capital gains, which can provide huge tax savings to compensate for this.
This produce is more suited for people who have huge capital gain liability (say on sale of capital assets such as property, land, sale of stocks within a year of acquisition, etc.)
The ET Wealth supplement on Mondays shows several cases where people (investors) bought ULIPs, money back policies and other insurance cum investment products, which are not beneficial.
The issue is that investors neither get sufficient insurance cover and the investment is not as good as mutual funds and other investment products.
Added to this the premiums are very high or unaffordable. Due to the high premiums some people let the policy/plan elapse and lose some more in the process. If you really want to make your life easier, just stick to pure term insurance plans.
Now that we know the pitfalls of tax savings instruments we need to look at investing beyond just tax benefits or savings. This does not mean you should ignore the tax benefits altogether, but selectively pick a few products that meet your needs, while also saving some tax as an additional benefit.
A few points that one should keep in mind while choosing a tax saving investments:
- Does it just provide tax savings or other benefits as well? For instance life insurance for the breadwinner in the family provides a shield or cover for the family against any eventualities.
- Ask this question “Will I buy this product if there were no tax benefits?” If your answer is ‘No’, try to avoid or postpone the decision. Its better to pay tax rather than buy some defunct product which becomes a drag on your finances.
- Avoid High Cost Products :- Good examples of these are ULIPs and savings based insurance products. Don’t commit to savings plans or investments that force you to invest huge sums every month.
- Term of Investments :- Don’t lock your hard earned money for several years just to save a few thousands. You may need these funds in future for emergency needs or for other important commitments. Having this flexibility to redeem your investments is important.
- Returns :- Ensure that you get decent returns, particularly when you are locking money for several years.
- Tax Free Instruments:- Don’t fall in to the trap of investing for the sole benefit of the returns being tax free. For instance the interest on Government bonds is tax free but returns are low.
- Explore Alternate Tax Provision:- Most people are familiar with Sec 80 C, however there are other sections such as Sec 80D (medclaim), Sec 80E, deduction for interest on housing loan, etc.
- Systematic Planning :- Start planning your taxes in the early part of the financial year rather than waiting till February or March, so that you have sufficient time to explore various options and to allocate funds.
Conclusion – Tax Saving Investments
To sum up I would say that its practically not possible for high income people to reduce their taxable income to zero. Beyond a certain limit one will still have some income, which will be taxable.
The best idea is to pick a few tax savings product and pay the tax and file your returns on time and sleep peacefully instead of locking up your hard earned money just to save a few thousands. When you plan your tax this year, pick only those tax saving investments/tax saving products, which benefit you in your overall financial planning strategy.