Introduction
It is the busy month of March and the tax planning season is at its peak as it is the last month to make investments in tax saving products to avail maximum income tax benefits. David is a 22 year old person working in an MNC. He will be filing his income tax returns for the 1st time. The entire year David did not do anything about his tax planning and hence the last minute scramble to look for financial products to save tax.
David is getting calls from various life insurance agents, mutual fund advisors and bank sales guys etc with each of them explaining to him how their company products are superior in terms of generating handsome returns and tax benefits are compared to products offered by other companies. After receiving so many calls from so many companies and listening to so many options, at the end of the day David is a confused man and is not able to make up his mind on which financial product to go for to save tax. But at the same time if he does not decide quickly he will end up pay a hefty amount of his hard earned money as income tax.
Does this situation sound similar to your own situation which you face in March every year? There are lot of people who face this dilemma just like David as they don't understand the various financial products available for saving tax and the characteristics of these financial products. Through this article we are making an attempt to list some of the financial products and their characteristics (features).
Section 80C
There are various tax saving products available in which investors can invest for returns and at the same time save tax. The government in order to encourage savings and investments among people gives tax benefits for investments made in certain financial products. These financial products are covered in detail under Section 80C of the Income Tax Act.
Under Section 80C investment upto a limit of INR 1,00,000 made in these financial products qualify for deduction from taxable income. In short it means the person is not required to pay income tax on investments upto INR 1,00,000 made in financial products specified under Section 80C of the Income Tax Act. So a person falling in the highest tax bracket of 30% can save upto INR 30,000 in tax by utilizing the entire limit of Section 80C.
Financial Products covered under Section 80C: The various financial products covered under Section 80C of the Income Tax Act are as follows:
- Employee Provident Fund (EPF)
- Five Year Bank Fixed Deposits
- Public Provident Fund (PPF)
- Senior Citizen Savings Scheme (SCSS)
- Equity Linked Saving Schemes (ELSS)
- Life Insurance
- Unit Linked Insurance Plans (ULIPs)
- National Savings Certificates (NSC)
- Pension Plans
- Home Loan Principal Repayment
- Tuition fees paid for Children
The list is modified and new products are added to the list and existing products are removed from the list from time to time.
Factors to be considered for Investments
An investor has lot of investment options that he can choose from before he selects the ones in which he wants to invest. Every product has its own features. Some of the factors that an investor may consider before he selects the product that he wants to invest in are as follows:
- Tax Treatment on Maturity: There are many products that offer tax deduction at the time of investment but not all products offer tax exemption on returns at the time of taking the maturity proceeds.
For example Ganesh invests INR 1,00,000 in a 5 year tax saver bank FD offering 8% p.a. Ganesh's investment of INR 1,00,000 qualifies for tax deduction under Section 80C at the time of investment. After 5 years Ganesh will get back his principal of INR 1,00,000 and the interest accumulated on it. The interest that Ganesh gets at the maturity of the FD is taxable. So this reduces the overall returns of the product. The post tax returns will be lower than the original 8% at which the money was invested.
In case of a Public Provident Fund (PPF) an investor gets tax benefits at the time of investment. The maturity proceeds received at the maturity are also tax free. In case of life insurance the maturity proceeds or the death benefit amount received is tax free.
- EEE and EET: Investment products that get tax benefits at all the 3 stages i.e. the investment stage, the accrual (accumulation) stage and maturity stage fall under the Exempt-Exempt-Exempt (EEE) tax status. PPF, ELSS and Life Insurance fall under EEE tax status. Investment products that get tax benefits at the investment stage and the accrual (accumulation) stage and are taxed at the maturity stage fall under the Exempt-Exempt-Tax (EET) tax status. Bank Fixed Deposits fall under EET tax status. With the Government planning to introduce the new Direct Tax Code from 2011, the Government plans to move a lot of investment products from EEE to EET wherein these products will be taxed at the maturity stage.
- Investment Horizon: Investors need to consider the time horizon for investment before deciding to invest in a product. Some products like Equity Linked Savings Schemes (ELSS) have a lock-in period of 3 years.
Tax saving Bank FD's have a lock-in period of 5 years and the tenure of PPF is 15 years. But PPF allows partial withdrawals during the tenure of the investment period. A long term investor, who doesn't need money for a long time, may invest in long term investment products like life insurance or PPF. An investor who has short term goals may invest in short term products like ELSS plans or tax saving bank FD. Senior Citizen Savings Scheme FD has tenure of 5 years and NSC of 6 years.
- Risk and Returns: An investor may consider the risk involved and returns given by financial product before choosing the product to invest in. An investor with a high risk appetite looking for high returns may invest in an equity market linked instrument like ELSS plan or a Unit Linked Insurance Plan (ULIP). An investor with a low risk appetite looking for steady returns may invest in fixed return financial products like PPF, NSC, KVP or tax saving bank FD.
- Maximum Investment Limit: An investor may consider the maximum investment limit before choosing a financial product. For example the maximum amount that can be invested in PPF in a year is INR 70,000. So if an investor chooses only PPF for tax saving investment, he will not be able to exhaust his entire allowed deduction limit of INR 1,00,000. In case of ELSS and ULIPs there is no maximum investment limit, but income tax benefits can be availed only for INR 1,00,000 in a financial year.
- Liquidity: Most tax saving investment products come with a lock-in period. An investor may consider the liquidity provided by the financial product before selecting it for investment. For example PPF allows partial withdrawal during the 15 years tenure of the investment. Tax savings bank FD cannot be broken before maturity and also banks normally don't give loans against these FD's. Traditional Life insurance policies and ULIPs allow partial withdrawals but only after completion of 3 years. The investor can also take loans against life insurance policies. An investor can also take loan against KVP and NSC Certificates.
- Inflation protection: An investor may look to invest in financial products that offer returns that can beat inflation. Low fixed returns products are avoided by investors during periods of high inflation as they yield negative returns when inflation is higher than the returns given by these products. Inflation silently erodes the value of the investment over a period of time. In the long run equities have consistently given higher inflation adjusted returns than returns given fixed return securities.
The following table compares the characteristics of various financial products
|
| Maturity Tax Treatment | Time Horizon | Risk & Returns | Maximum Investment Limit | Liquidity | Inflation Protection |
| EPF | No, if less than 5 years | Till Retirement | Low | % of basic salary | Low | Low |
| PPF | Yes | 15 Years | Low | Rs 70,000 p.a. | Medium | Low |
| Bank FD | No | 5 Years | Low | No Limit | Low | Low |
| ELSS | Yes | No Limit | High | No Limit | High | Yes |
| Life Insurance | Yes | No Limit | Medium | No Limit | Medium | Low |
| SCSS | No | 5 Years | Low | Rs 15,00,000 | Low | Low |
| ULIP | Yes | 10 to 30 Years | High | No Limit | Medium | High |
| NSC | Yes | 6 Years | Low | No Limit | Medium | Low |
Conclusion
Based on the investment objective the investor should select the financial product to invest in. The investor should consider all the above characteristics of investment products before selecting the product so that it fulfils the investment objective of the investor. The ultimate objective of the investor should be long term wealth creation and not just mere tax saving. Income tax benefits should be used to enhance the total returns from financial products to meet the objective of wealth creation.
