Albert Einstein once remarked that ‘the hardest thing to understand in the world is Income Tax’. Having said that, Tax Planning is still a complicated task to many these days. Investing in Tax saving schemes to save tax lawfully is the most important task to keep your hard earned money with you. Most of us try to invest in an insurance policies, bank tax saving FD’s, tax saving mutual funds etc., at the end of the year just to save tax. This is the biggest mistake that everyone is doing to save tax.
We do invest in Tax saving schemes to save money. But did you ever thought that we are losing money by investing in Tax Saving avenues like life insurance and mediclaim policies or investing in tax saving mutual funds, ULIPS, PPF, NSC and so on without having a specific goal in mind and earning fewer returns than you could earn? This is the topic of this post. I will give some tips to do Tax Planning effectively in line with your goals.
What is Tax Planning
Tax planning is the act of investing in right investment vehicles that provide a way to save tax as well as supporting your future goals.
Last minute rush will force you to invest in investment vehicles that you don’t need or investments that give low returns. This will hurt your financial health.
To avoid this, One should not look at tax planning and goal based investments separately. By separating the two, you are investing in unnecessary instruments which are of no use. You might be thinking that you can assign these returns to some expense when you receive them. This kind of mentality cannot be called as Planning. If you are super rich, you don’t mind this mentality but for people who are trying to level up their financial status should care about planning your financials. Let me explain Financial planning or goal based investing for newcomers to investing world.
Financial Planning is all about planning finances on the basis of goals and segregating the goals into short, medium and long-term and invest accordingly into instruments suitable for short term and long term separately. Saving for the goals in a suitable manner will enable you to reach your goals successfully and on time. Tax planning should be in line with these goals.
Cost of Investing in the Wrong Fund
One of the most wrongdoings by the taxpayers is that they pick instruments randomly which is hot in the market. They don’t give a thought whether that instrument suits their need. You should avoid this mistake.
Let me explain this with an example. Let’s assume that you are investing in your child graduation for which you have 10 years to reach this goal. This is a long term. You should invest in equity-related mutual funds in SIP mode. But to save tax your so-called friend told you to invest in some X Insurance scheme to save tax of Rs.45000. You have blindly invested lump sum 1.5 Lakh by thinking that you could assign this to your child graduation. You might continue to do this same this for the next 10 years because you are saving Rs.45k.
Now, If you had invested this amount monthly in an equity-related mutual fund for 7 years (You should exit from equity investments before 3 years to reach the goal), you could have earned 12 to 15% return on your invested capital of Rs.10.50 Lakhs. The total corpus would be Rs.16.5 Lakh(At 12% ROI). The amount that you have invested in insurance policies would return Rs.14.45 lakhs in 7 years period. (I have taken 7 years for comparison purpose)
You could also invest in Tax Saving Mutual Funds (ELSS) to save tax. But you have invested in an insurance policy which you don’t need and end up earning less than what you could earn. This kind of misselling by insurance agents is very common. So, just think about the investment vehicle that you choose to invest and the returns that you could earn.
Investment Vehicles for Saving Tax
There are so many tax saving instruments available but every instrument is not suitable for every taxpayer.
You should learn –
- Lock-in period of tax saver
- Tax implications on funds you receive after maturity
- Penalty on Premature withdrawal
- Final Returns
- Loan Facility
You should better learn these things before investing and choose the best of all as per your goals. I will explain each and every tax savers available in the market and the features mentioned above in detail. All views expressed here under are just my personal views. You should take your own decision before investing your hard-earned money.
Life Insurance: You should never invest in any Insurance Plans for tax saving purpose. Life Insurance should protect your dependents financial status even when you are not around. It should not be treated as an investment vehicle to earn some returns and it should not be in your portfolio to save tax. Insurance is meant for Risk Cover. For this purpose, one should opt for Term Insurance Plan.
So there is no point in looking at above-mentioned features in an Insurance plan.
PPF: It has a lock-in period of 15 years. The risk is very low as it is guaranteed by GOI. Loan Facility available. You can take premature withdrawals. Expected return is around 8%. Returns are tax exempted. What makes PFF a difficult choice is that it provides low returns for the longer lock-in period. It is not a suitable combination. If your goal is 15 years far, you could invest in some risky assets and earn more returns than 8%. It doesn’t suit for both short-term as well as long-term.
NSC: Lock-in period of 6 years. The risk is very low as it is guaranteed by GOI. Loan Facility not available. Premature withdrawals not allowed. Expected return is around 7 – 8%. Strictly you should lock your funds for 6 years as there is no loan facility and premature withdrawal. You should decide whether they are suitable for you or not. It is better to avoid schemes which do not allow loan and premature withdrawal.
5-Year Bank FD: Lock-in period of 5 years. The risk is low as there is a guaranty cover up to 1 lakh on your deposits. Loan Facility not available. Premature withdrawals allowed with some penalty. Expected return is around 6 – 8%. You might choose this option if your risk-taking ability is low. Having premature withdrawal facility make it a better option than NSC.
Tax Saving Mutual Funds (ELSS): Lock-in period of 3 years. The risk is high as you are dealing with equities. Loan Facility not available. Premature withdrawals not allowed. Expected return is around 10 – 12% (if you can choose best options). Even though there is no loan facility and premature withdrawal, the lock-in period is just 3 years and expected returns are above 10% makes it a better option for goals above 3 years.
From April 1, 2018 any equity MFs that have an equity exposure of 65% or more including Equity-linked savings schemes (ELSS) will have to pay a 10% tax on long-term gains. It is important to note that gains made above Rs 1 lakh per annum will only be subject to tax and any gains made below that limit in one FY remains tax-exempt.
All the above-mentioned investment vehicles come under Section 80C of IT Act. Now let’s find some other tax saving schemes other than Sec.80C, which provide the additional tax deduction.
NPS: Lock-in period up to the age 60. The risk is moderately high as you are dealing with equities and debt combined. Loan Facility available. Premature withdrawals allowed after 3 years. Expected return is around 10 – 12% (if you can choose best fund manager). Up to Rs.50K additional deduction is allowed under Section 80CCD (1b) of IT act apart from 1.5Lakh deduction under Section 80C. The additional 50K deduction along with Rs.1.5 Lakh deduction make it a better option for retirement planning as well as to save tax. You can learn more about New Pension Scheme (NPS) here.
Health Insurance: Sec 80D of IT Act provides additional tax benefit if you purchase a health insurance plan. It cannot be chosen as an investment vehicle. So there is no point of explaining all other features. But this is a must have plan in your portfolio. You can get the maximum deduction of Rs.25,000/- for health insurance premium you paid. For senior citizens, this limit is Rs.30k.
House Property: If you are planning to own a house, it is better to have one early in your life. You should also consider the EMI amount which should not disturb your other goals. Principle repaid comes under Sec.80C and interest paid or accrued comes under Sec 24(b). The total amount allowed towards this deduction under Sec.80 is Rs.1.5 Lakh and under Sec 24(b) is Rs 2 Lakh in case of both occupied as well as let-out or a deemed to be let out property, from Financial Year 2017-18.
How to Plan Your Taxes
Instead of investing in tax saving schemes which comes under Sec 80C, one should also cover their finances so as to cover the other sections to save more tax. To claim 1.5 Lakh deduction, one can choose to invest in either ELSS or construct a house by taking a loan from a financial institution if they are planning to have one. Health Insurance is a must for every individual or family to protect against growing medical expenses.
Instruments for Long-Term Tax Savings:
Tax saving instruments are long-term focused. You find many options in this category.
- Bank FD’s
- Tax Saving Corporate Bonds
Instruments for Short-Term Tax Savings:
I feel there is not a single option available for short-term goals. You should invest your money in short-term funds to grow your wealth but not to save tax. But you should invest in schemes which have less taxation on returns.
|Taxation on different types of mutual funds|
|STCG Tax||LTCG Tax|
|Equity mutual funds||15%||10% on LTCG in excess of Rs. 1 Lakh|
|Balanced mutual funds||15%||10% on LTCG in excess of Rs. 1 Lakh|
|Debt mutual funds||As per tax slab||20% after indexation|
Finally, I want to reiterate that, your tax planning instruments should be part of your goal based investments. Don’t segregate them. I have explained the importance of tax planning & methods of tax planning in this article. Hope You Like It… If so, Do Share It…
If you need any other details or clarifications, please do comment below. I will try to reply ASAP. Happy Investing…
Disclaimer: The views expressed in this article are just my views and the returns mentioned in this article are taken from my personal experience and few resources available online. This is for educational purpose but not any recommendation to invest in any particular asset or plan. Do your own research before taking your investment decisions. Thank You…