01 August, 2011

Investing tax efficiently can mean whether one meets the goals or not

Most people are super-conscious about tax savings… I mean, they would go to any lengths to take advantage of Sec 80C limit of Rs.1 Lakh. They would want to go for medical insurance just to take advantage of the Rs.15,000/-pa available under Sec 80D. Even if they are in the lowest income tax bracket of 10%, many would still want to invest in infrastructure bonds, though it has a lock-in period of at least 5 years. When people are so keen to save tax upfront, why would they want to pay taxes on the money they are earning, especially if they can structure it in a way, they need not?

Let us take an example to understand this. Ram invested Rs.30,000/- in NSC and Rs.40,000/- in PPF in the previous Financial year. While the amount of tax saved is identical in the year of investment, the interest income accrued from these two, are taxed in different ways. NSC interest is taxable in the hands of the investor, when they get the money after six years. The return would be 30.9% less ( that would be the tax outgo in the highest bracket ), when they get the money back. However, PPF is entirely tax free. Hence, the entire amount one gets is tax-free. Though both of them have offered similar returns, the actual returns they have offered is vastly different. Ram could have invested the entire Rs.70,000/- in PPF and could have ensured a higher return for himself… that is assuming that he is willing to lock-in his PPF investments for 15 years. A simple decision can make such a lot of difference.

Now, look at regular investments… many invest in bank FDs. In fact, it is a vehicle of choice for our citizens, many of whom are risk averse. But, apart from PPF, is there a better, higher yielding alternative of lower duration? The answer is in the affirmative. You have heard them – Fixed Maturity Plans ( FMPs ), the current darling of the MF industry.

These products invest in a basket of securities which include Bank CDs, Company commercial paper, structured obligations, Bonds etc. – meaning, all these are debt products and FMP is a 100% debt product. So, how is it going to give a better yield? Are the components more risky than a Bank FD? If it has other than Bank CDs in it’s portfolio, then the risk profile is going to be higher. Does, that explain the better returns we are talking about? To some extent, that explains a potentially higher yield. But, the other aspect is the tax treatment of FMPs, which is far more benign… if one gets a dividend, it is tax-free. Dividend distribution tax would be 13.52%, which would be paid by the company and indirectly the investor would be paying it… much better than paying 30+% tax!

In the growth option, it can be 10% without indexation and 20% with indexation. Now the 20% with indexation option, used to ensure little by way of taxes. That could change with the advent of DTC. DTC as proposed says that after indexation the capital gains will be subject to tax at the income tax slab rates. Also, Dividend is proposed to be added to income. These could affect the attractiveness. But still growth option where tax applies after indexation is always better than paying tax directly on interest earned.

Why did I not mention Equity MFs and Equity? Yeah. The income after a year in these are treated as capital gains and are currently nil. That makes them very attractive. But they are a different asset class altogether and can give higher returns but come with higher risk too.

In substance, one should look at the tax incidence / savings on the product over the product life cycle and not only while investing. That can mean a difference Lakhs of rupees over one’s lifetime. That could be all the difference between achieving your goal or adjusting & making compromises. If you just get that, you have learned more than enough for a day!

Authored by Suresh Sadagopan ; Published in Moneycontrol.com on 27/7/2011

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