Tax planning must always been seen within the broader framework of financial planning and never in isolation.
Most of the people end up reacting to tax (at the end of the financial year) rather than looking at it as an investment that must be considered all the year through.
This myopic view of tax savings causes a lot of harm to individuals in the form of lower post tax income, higher costs and a hodgepodge of investments accumulated over a period of years.
Here are some of our thoughts on how one should look at tax planning within financial planning.
Take a broad perspective
Do you need a house? Go for it. You will get a deduction on the principal investment as well as the interest component of the loan.
Incidentally, though not an investment, you can claim a deduction under Section 80C if you are paying your children's fees.
Debt
If you want a fixed return investment, then you have quite a few options.
If you are a salaried employee, opt for the Voluntary Provident Fund.
Also opt for the Public Provident Fund, though you do not need to be a salaried employee for this one. Anyone can open a PPF account.
Though some insurance options and National Savings Certificate also fall into this category, the VPF and PPF remain the best debt investments so far.
Do read PPF vs NSC and PPF vs VPF.
Insurance
Have you considered insurance? The premium is covered under Section 80C.
Do you have any dependents? If you do need insurance, go for the pure risk cover also known as term insurance. This is the purest and cheapest form of life insurance.
Let's say you are a 25-year old male and you take a term insurance for Rs 10 lakh (Rs 1 million) for 15 years. Should you die during this period, your nominee/ beneficiary will get Rs 10 lakh. The annual premium that you will be just Rs 2,890.
We are of the view that if you visit an insurance company, opt for insurance only. Don't look at an insurance company for investments.
Equity
Unit Linked Insurance Plans are very popular these days. These are offered by insurance companies and offer a tax benefit under Section 80C. They double up as mutual funds and life insurance.
Insurance companies never fail to tout the benefits of insurance as an investment product. Incidentally, February to March is the time period when most insurance and ULIP policies are sold.
You can comfortably skip ULIPs. Due to the transaction costs, sales costs and high commissions, ULIPs eat into your returns.
We strongly advocate looking at Equity Linked Savings Schemes instead. These are mutual funds that invest in stocks and give a tax benefit under Section 80C.
If you are young and are in it for the long haul, equity is the best asset class since it beats inflation. With a strong growth rate in the economy and a healthy rise in corporate earnings, equities should be able to trump inflation comfortably over the next few years.
Also, ELSS often do better than open-ended (can buy and sell units anytime) diversified equity funds. This is due to the three-year lock-in period. This keeps the corpus stable and fund managers can take long-term bets knowing that the money will not be pulled out suddenly.
So, the fund manager can pick up stocks that may score a bit low on liquidity but are available at substantial discounts and wait for the value to get unlocked (market to recognise the stock and the price to rise).
Since the fund manager need not grapple with redemption (selling of units) pressure every day, he can remain fully invested in equities. Other fund managers hold a portion in cash, which yield low or no returns.
Making the right choice
While PPF has a limit of Rs 70,000, ELSS does not have any limit and you can invest the entire Rs 1,00,000 in it. Neither does NSC have a limit.
When compared with PPF, NSC and other tax saving instruments, the returns from ELSS are the highest.
In the three-year period ending December 7, 2005, that category of funds gave an average return of 58%. Funds like Magnum Taxgain, HDFC Taxsaver, and HDFC Long Term Advantage* generated sensational returns -- all of them have appreciated by more than 75% during the period.
But there is one caveat: Even as equities provide high returns over the long term, it is a risky asset class. It is prone to volatility.
Unlike PPF and NSC, the returns are not guaranteed. In ELSS, a bad choice has the potential to derail one's investment plans. So an informed decision here is crucial.
Also, unlike PPF and NSC where investing at one go does not have any significant impact on the future prospects of investments, lump-sum investment in an equity fund could be disastrous.
A much better strategy would be to plan one's tax-saving investments during the start of the year itself and allocate money to ELSS every month.
The final step (and the trickiest one) would be to decide which fund to invest in. And as the choice is increasing, choosing a fund is going to be even more difficult. Since tax-planning funds come with a lock-in of three years, a poor decision means there's no way out immediately. Therefore, investors should choose their funds with utmost care.
The rule of the game is the same here: funds with proven track record in good as well bad times, experienced managers, and a systematic investment plan. The best way to invest in ELSS is to buy units worth a fixed amount of money every month. In other words, invest systematically.
Look at post-tax returns
Have you just been saving tax (mandatorily investing in Section 80C instruments to minimise tax)? For instance, just buying one life insurance policy after another to get the benefit under Section 80C?
Or, do you look at post-tax returns (invest with the idea of getting the maximum returns after you pay your taxes)? So you consider ELSS and other investments.
In other words, are you investing only for the tax benefits or are you investing for the future?
You must list out the goals you are saving for. That will help you decide how much you need and when and how much of risk you are willing to take. Once you are clear on this, do your tax planning within this framework.
When looking at the Rs 1,00,000 component under Section 80C, keep all the above parameters in mind. Then you can decide how much should go into equity and debt. If you are young, be more aggressive and let equity form the bulk of your portfolio.
The trick to investing smartly and boosting returns lies in investing in a combination of debt, equity and real estate to maximise post-tax income.
* The three funds mentioned here are not a recommendation to buy or invest. Please research mutual funds carefully before investing.
Amar Pandit is a certified financial planner and runs the Mumbai-based firm My Financial Advisor.
