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A Stitch In Time Saves Nine

Author: Sunil Kumar Singh/Tuesday, February 23, 2010/Categories: Tax

A Stitch In Time Saves Nine

Albert Einstein is said to have once remarked that ‘the hardest thing to understand in the world is the income tax.’ Planning for tax-saving investments however continues to bog millions of taxpayers even to this day. There is hardly any salaried Indian taxpayer who doesn’t invest in any form of tax saving instruments: buying life insurance and mediclaim policies; investing in ULIPs, PPF, NSC, tax-saving mutual funds, and so on.
But what many of them don’t do is — well thought-out planning. In many cases, the investment they rush to make at the eleventh hour often proves to be just a yearly ritual — it’s seldom properly planned and is mostly done hastily in the fag-end of a financial year, i.e. between January-March. The result: taxpayers end up sitting on saving instruments that either they don’t need (simply because either an agent mis-sold the product or they randomly picked up any product) or investments that give abysmally low benefits.
However, early-in-the-year, smart tax planning  can get you out of this quandary.  And don’t need to wait for the ides of March to decide on tax saving instruments. Let’s first understand what tax planning exactly is and how to go
 about it.

Smart Tax Planning
Tax planning is one of the most poorly planned and least cared for aspects of the overall financial planning. The objective of tax planning is clear — to minimize tax liability in a lawful manner. However, you shouldn’t invest casually in tax saving instruments just to show them as investment proofs to your employer to prevent more tax cut from your salary. You should rather be a smart tax planner to get the real benefits of tax planning! 
The first requirement to be a smart tax planner is that you must look at tax planning as a critical component of your overall financial planning. Financial advisors and tax consultants believe that most of the taxpayers end up segregating tax planning and financial planning, which is a wrong approach. By separating the two, they take a short term view (usually one year) for tax planning and long term view for financial planning, whereas they should move in tandem.
“Financial planning is all about planning finances on basis of goals/needs and segregating them into short, medium and long term and invest accordingly into instruments suitable for short term & long term separately. Savings in a disciplined manner and on a monthly basis would provide corpus for both short term expenses and long term goals. Tax planning is one of key elements in segregating investments between short term & long term,” maintains Kiran Kumar Kavikondala, Director, WealthRays Group, Bangalore.
The short term financial or tax planning, he says, is suitable to meet monthly/yearly expenses like life/vehicle insurance premiums, children school fees, etc. Long-term financial/tax planning on the other hand is suitable to plan for medium to long term goals like educational loans, home loans, children’s higher education/marriage expense planning, retirement corpus, etc as well as for tax savings.

Pick Instruments Carefully
One of the commonest follies taxpayers make is to go and pick any tax saving instrument randomly, without sparing a thought on whether that instruments suits them or not and without evaluating their inherent strengths. There are scores of tax saving instruments available but every instrument is not suitable for every tax payer.
Experts advise that each instrument needs to be looked at separately with focus on not just tax but on several other aspects to like risk-return analysis, lock-in (if any), tax on receipt of funds post lock in, availability of any loan facility during lock-in and penalty for pre-mature withdrawal, etc.
As Jaya K Nagarmat, MD, Investor Shoppe, Mumbai maintains, “Picking the right instruments for tax saving would normally depend on a person’s risk appetite, his existing asset allocation and his disposable income to be able to invest in all the available sections for tax saving.”
For instance, if you’re looking to park some money in life insurance policies for tax saving only, be careful, as experts add that you should look at insurance from death/accidental cover rather than tax and investment point of view.
“Insurance is primarily meant for risk cover. To encourage savings and risk cover through insurance, tax benefits are bestowed upon insurance policies,” argues Kavikondala.
Take another instance of the tax exemption on home loan. It’s an instrument that can give you many advantages. Many home loan borrowers believe in a myth that deduction on interest payable on loan taken for purchase of house is restricted to Rs 150,000 irrespective of the status of the house. Actually, if the house is let out (or even deemed to be let out) then the restriction does not apply.
And therefore, as Vaibhav Sankla, Director, H&R Block India, Pune maintains, “If you are paying interest in larger amounts then you can consider an option of staying in a rented accommodation and claim HRA exemption, and letting out your own house and claiming the \deduction on the entire amount of interest on loan taken for purchase of the house.”
Other important points are that even processing fees, prepayment charges and foreclosure charges are considered as interest and are allowable as deduction. Lastly, interest on loans taken even from family members or friends is eligible for tax deduction. What is important is that the loan should be utilized for the purchase/construction/renovation of house, he adds.

80C: A Limited Basket
For scores of taxpayers, tax planning is all about investing in instruments prescribed under Section 80C of the Income Tax Act. However, by doing so they end up concentrating too much on Section 80C that allows certain investments and expenditure upto a maximum of Rs 1 lakh to be tax-exempt. The section lists down instruments such as a life insurance or a Unit-Linked Insurance Plan (ULIP); contribution to a retirement benefit plan or pension plan by an insurance company or a mutual fund; contribution in Employees Provident Fund (EPF); National Savings Certificates (NSC); Equity Linked Savings Scheme (ELSS); 5-year tax-saving bank FDs; Public Provident Find (PPF) and Senior Citizens’ Savings Scheme.
Experts however advise that instead of exhausting investment on one Section only, taxpayers should invest and make use of other sections of the IT Act too that give tax rebate (See Box: Tax-saving Options Beyond 80C).
Adds Mahesh Padmanabhan, Director, Relaxwithtax Consultants, Mumbai: “While section 80C and a couple of other sections (viz., Section 80CCC – Pension Funds, 80CCG – Rajiv Gandhi Equity Saving Scheme) are investment driven there are other sections such as section 80D – Payment of health insurance premium – that are expense oriented.”
Let’s understand it further by an illustration. Suppose there’s a salaried male individual below 60 whose gross total income is Rs 8,00,000 (8 lakh per annum). Without claiming any deductions, the taxpayer will pay taxes of Rs 92,700 (including education cess). However, if the person does smart tax planning and invests not only in Section 80C instruments but in a mix of instruments prescribed under other Sections his tax liability would be greatly reduced.
As Alok Agrawal, Director - Tax & Regulatory services, Ernst & Young (E&Y) says: “If the taxpayer makes the following investments the tax outflow will be Rs 23,175 resulting in a tax saving of Rs 71,525 (77%).”
As a first step, Agrawal says, he can invest in Section 80C savings that allows deduction upto Rs 100,000 and the taxpayer has options to choose from a mixture of traditional saving and market linked saving options. 
The next step is investment in house property by way of loan from a financial institution where deduction is available upto Rs 250,000 on interest paid to financial institution (Rs 150,000 under section 24(b) and an additional deduction of Rs 100,000 under section 80EE of the Act).
However, deduction under Section 80EE is subject to various conditions viz., the taxpayer does not have a residential property at the time of sanctioning of loan, date of sanctioning of loan, loan quantum, value of property, etc. 
Another instrument where the person can invest to save tax is investment in equity market (under Section 80CCG) where deduction is available upto Rs 25,000 or 50% of the investment made. However, this option is available for first time investors in listed equity and/ or equity oriented mutual funds. Moreover, as Agrawal adds, this investment is subject to the detailed equity savings schemes guidelines framed by the tax authorities.
Besides, he can claim deduction of interest on savings bank account upto a maximum deduction of Rs 10,000. Further, Agrawal says, investment in equity oriented mutual funds could result in tax savings on interim income (dividends are exempt) and redemption (long term capital gains).

Balancing Act: Traditional & Market-linked Investments
Another aspect of smart tax planning is that you should keep a fine balance between traditional saving schemes (such as PPF, NSC, tax-saving FDs) and market-linked investments (such as ULIPs and ELSS). The thumb rule i.e. 100 minus age investment that says an individual of age 30 might invest 70% in equity instruments and 30% in debt instruments, might not work well for all taxpayers.
As Padmanabhan maintains, “The dependency of choice of the investment instrument is mainly the risk appetite of the individual and hence the composition would definitely hinge on this parameter.”
He says when investing in debt instruments, focus should be on investments that generate tax-free investments. Case in point here is say PPF vis-à-vis say NSC or tax-saving FD. If we assume that the rate of interest for all three investment options is say 8.5% and a person can invest say Rs 100,000 every year for 15 years then an investment in PPF might generate approximately Rs 30.60 lakh after 15 years. The same investment in NSC or FD would generate approximately Rs 24.40 lakh after accounting for the tax liability at highest rate.
Hence we can note the visible impact of tax based on the choice of your investment even within debt instruments, he adds.
Experts also add that since each investment instrument has its own pros and cons, one should be cautious while picking an instrument.
As Agrawal of E&Y says: “An aggressive investor would like to invest in
instruments which give him higher rate of return (for example ULIPs and ELSS which are market linked), whereas a risk averse person would like to invest in ‘safe instruments’ (PPF, NSC which give lower return when compared to market linked but high on preserving capital/ principal).”
ELSS Vs ULIPs Vs FDs
Tax savings mutual funds (Equity Linked Savings Scheme), ULIPs (Unit Linked Insurance or Investment Plans) and tax-saving bank fixed deposits are among many investments avenues where you can invest to avail income tax rebate. But remember each instrument has its own shortcomings and experts advise to choose your investments according to your requirement and risk appetite to save tax.
ULIPs, as the name suggests, combine insurance and investment plan with a lock-in period of five years, from earlier three years. Once the darling of investors, ULIPs however lost investor favour especially during the last couple of years because of dwindling returns. Many taxpayers got their fingers burned simply because the return was market-linked. However, as equity markets are looking bullish so far this year, ULIPs could regain their lost charm.
ELSS, another market-linked product, is a type of diversified equity mutual fund enabling investors to avail tax rebates under Section 80 C of the Income Tax Act upto Rs one lakh. These funds come with a lock-in period of three years, the shortest lock-in period compared to other tax saving options, and the minimum investment amount is Rs 500.
There’s no quick fix when it comes to investment, especially market-linked instruments and experts advise that the key strength of market linked instrument is visible only on length of investing and holding of the instrument.
As Padmanabhan of Relaxwithtax Consultants  maintains, “As ELSS is one great way of generating wealth as also reducing tax. Yes reasonable degree of monitoring of performance is needed to ensure that you are invested in a well managed tax fund but it goes a long way in delivering a sizeable corpus over long time frame. Also, Systematic Investment Plans (SIP) should be opted so that the investment is evenly spread out.”
Adds Sumeet Vaid, CEO, Ffreedom financial planners, “Since the majority (80%) of the investment is done in equity so there is a potential risk of capital erosion. Another point is that liquidity in ELSS is limited since there’s a lock-in period of three years.
Five-year tax-saving FDs are special category of fixed deposits. These are instruments for saving tax as well as earning high returns. In the Finance Bill of 2006, the government had announced tax benefits to bank term deposits booked by an individual resident Indian/HUF which are of over five year tenure and up to Rs 1,00,000 under Section 80C of IT Act. The minimum amount for opening such FDs varies as per banks. Generally, the minimum amount is Rs 100. However, there is a maximum limit of Rs 1 lakh for opening such FDs in a financial year.
“These FDs have 5 years lock-in-periods and the biggest disadvantage of these FDs is that you can’t withdraw your money before maturity and there is a tax on Interest income you earn,” cautions Vaid.
So, don’t just pick a tax-saving instrument just because someone told you so. Discuss your needs and objectives with a financial planner or an investment and tax consultant before parking money. 

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