23 May, 2011

A little diligence can make your investments tax efficient

There is an often heard line from our investors – ‘Please suggest me an investment that gives high returns and is low on risk’. Though there is so much coverage in the media that risk and return go hand in hand, this requirement has not gone away. It’s as elusive as experiencing snow fall in peak summer. The other aspect, which investors should be focusing on, but are neglecting, is the taxation and tax efficient investments.

Everyone wants to save on tax, under Sec 80C. But, that enthusiasm does not carry forward to finding out which could be the best investment vehicles for them. They talk of NSC, 5 year plus FD in Banks, PPF , ELSS Mutual Funds & Insurance, in the same breath. But, these are different investment vehicles in many ways.

Though NSC, PPF and bank FDs are all 100% debt instruments, their tenures and returns vary – especially their returns. The returns in Bank FD would be on similar lines like NSC. The tenures are also different – NSC has a 6 year tenure, FDs can have 5 years or more, PPF has a 15 year tenure. NSC gives 8% returns , which is fully taxable. The post tax returns are just 5.53% for a person at the highest tax slab. FDs return more or less the same post-tax returns. The returns in PPF is however, much higher at 8% post tax. If we look at other instruments like ELSS Funds from MFs, they are completely tax free after their lock in period of three years. The returns are variable ofcourse… but long-term returns in equity oriented assets are expected to be in double digits. Insurance is again a different ball game. Here, the returns are tax free at maturity. The returns depend on whether it is equity or debt investment that the insurance plan has invested in.

As part of Financial Planning for our clients, apart from tax savings in the year of investment ( Sec 80C), we look at tax efficiency and the returns after tax, over time. Apart from that, we look at the fit of the product in their portfolio. For that, we look at post tax returns, the asset class to which it belongs, risk inherent in the considered investment, tenure & liquidity before investing.
A product that has emerged as a good investment option to receive good post-tax returns is a Fixed Maturity Plan ( FMP ). One year Commercial Paper and Certificate of Deposits, into which most FMPs of that duration are investing, are giving returns of about 9.2-9.3% returns now. FMPs are eligible for indexation after one year at 20%. Accordingly, most FMPs are marginally over one year duration. The post-tax yield assuming an inflation factor of 7% is hence about 8.8%. This is an excellent return not available through most other options, in a pure debt product. While considering debt investments, these aspects need to be considered before putting together a portfolio.

Again, as a Financial Planner, tax efficiency needs to be considered while making provisions for liquidity too. Liquidity Margin that is maintained is typically 3 month’s expenses. This includes all loan repayments too. While providing for liquidity, it is a good idea to give a thought to how much to keep in the bank account and how much elsewhere. In a savings account, the money will earn a return of just 3.5%. However, if it were committed to a Money Manager Fund, it could earn 4.5-6% returns. Money Manager Funds should be invested in Dividend mode. Dividend Distribution tax applies every time they declare and pay a dividend. But this is at 14.16%. The interest earned in a savings account is lower and will be subjected to the tax applicable, as per one’s slab rates. Hence, investing in a Money Manager Fund is better in terms of returns and better in terms of tax treatment. If clients are more comfortable with keeping money in the bank, we suggest investing in sweep-in deposits, which earn more than a Savings Bank account (but then, the tax to be paid is as per the income tax slab ).

There are other aspects where tax efficiencies can be brought in. Many people are interested in buying Gold, due to the dream run in the metal in the last 3-4 years. Again, investing in physical gold has lots of negatives – like one has to pay a premium ( 5-15% ) for buying physical gold, even if it in the form of coins. One would need a locker, purity of gold can be an issue and one may not get the right price, when one goes to sell. Also, in physical gold it comes under Long-term Capital Gains regime, only after three years. Also, it is subject to wealth tax. As opposed to that, a Gold ETF, is very much like investing in Gold. One will not hold Gold in the physical form. Hence, the question of purity, storage, theft risk etc. are taken care of. Also, since it is in the form of MF units, it is eligible for Long-term Capital Gains treatment, after one year itself. Also, there is no wealth tax on Gold ETF units. Even if there is an end use for physical gold at a future point, the ETFs can always be converted to cash and physical Gold can be bought.
Taking a joint home loan ( where applicable ) allows the couple to individually claim upto Rs.1.5 Lakhs each of interest paid, for deduction from Salary Income. These and other efficiencies are integral to a financial planning process. Tax cannot be avoided, but it can be reduced by proper planning.

Article by Suresh Sadagopan ; Published in The Financial Chronicle on 23/2/2011

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