How to save taxes smartly

Have you ever thought about why you do your tax-saving investments? To save taxes of course, you might say! That, to my mind, is incidental. Do you know that a major chunk or perhaps the entire portion of your annual savings goes in to tax saving? And for many, there is no other significant saving avenue other than tax-saving investments. That makes it vital that you are ‘saving’ in good avenues that build wealth. Although you put away money for your short-term need of saving tax, remember, the money, in most cases, is locked in to long-term investments. That is even more reason why you have to plan to save taxes in options that deliver smart returns over the long term. Insurance for life cover Let us first list out the options available Yes, insurance, at least to the extent of adequately insuring your life, is a must. However, you do not need multiple insurance covers every year. Besides, an insurance product that tries to bundle a risk cover and some investment may not be the best of options viewed from both the cost angle, transparency and disclosure (given that bundled products become complex) as well as investment returns. Your other usual options would be your Employee’s Provident Fund (EPF), which is mostly deducted anyway from your salary; and then PPF, NSC and tax-saving fixed deposits. What do the above options give you? An upfront tax deduction benefit on the principal invested and an assured return of interest (which varies every year for EPF and PPF) that may or may not be taxable based on your option. The traditional investment options Now let us look at these options individually. EPF and PPF are government guaranteed products and therefore are good from the point of view of preserving your capital and earning decent returns. The tax exemption for interest also makes it a decent investment. However, if you notice the returns from these instruments, including the NSC, they have been on a steady decline. From 12% interest rate in the 1990s rates have now fallen to below 9% for close to 10 years now (except for 1 year in 2010-11). This, despite a very high inflation scenario of close to 5 years until last year. If you go for 5-year tax-saving FDs, the interest is entirely linked to bank deposits; and the entire interest is fully taxable in the year of maturity. This reduces the post tax returns of these instruments. Overall, much of what you save for tax purposes either goes towards low returning, safe options or towards life covers that are not avenues to build wealth. Tax-saving and wealth-building option Contemporary and regulated products such as tax-saving mutual funds help you build wealth for your goals and simultaneously save on taxes. Tax-saving mutual funds provide you a dual tax advantage – one, the amount invested qualifies for deduction from your income up to Rs 1.5 lakh a year. Two, the entire gains is exempt from tax (since it is an equity fund, if the units are held for over 1 year the gains, on sale are exempt). Besides, these funds have a 3-year lock in, which is far lower than traditional lock in periods. Why are tax-saving funds yet to catch on in a big way if there are smarter products? The reasons are as follows: one, there are no fixed returns; they are market linked. Investors used to low yielding fixed returns hesitate to invest in them. Two, given that it is an equity product, they are subject to market vagaries and can deliver negative returns over shorter time frames. How to invest in tax-saving funds However, an investor can mitigate the above risks in the following ways: one, although the lock in period for tax-saving mutual funds is only 3 years, it should ideally be held for at least 5 years or longer, thus reducing the chances of ill-timing the market. Two, a better option is to do a SIP (systematic investment plan) to reduce the risk of market timing and also average costs over market ups and downs. This also ensures that you do steady investments through the year for tax saving and do not struggle for funds for last minute tax saving. How much to invest If you are in your 20s and 30s you should be willing to take higher exposure to market-linked products such as tax-saving mutual funds. Hence, aside of 10-15% of your tax saving in pure life insurance, not less than 50% of your tax saving under 80C must be planned in tax-saving funds. The rest can be in traditional debt options such as EPF and PPF. If you are in your 40s or 50s then you consider reducing tax-saving mutual funds to 30-50% of your overall tax-saving investment. This is simply a thumb rule. If you have a high risk appetite and willing to give your investment a long period to build wealth, you can invest a larger chunk. Only, remember, not to react during temporary market falls. Over the long haul the returns would make up for the risks. Invest with a goal You need not save taxes blindly. Save taxes with a goal. Your tax-saving fund will be your equity allocation and your traditional options would provide you debt exposure. That means you have a mix of asset classes. Set aside a sum every month or every year, towards long-term goals such as children’s education or retirement. Expect reasonable returns (based on past long-term returns) and do the math using online calculators to set your goal. Save your money accordingly. Once your tax-saving money has a purpose to it – it becomes your wealth creating portfolio. Emerging products There are also more recent products such as the National Pension Scheme (NPS) that provide you with an additional Rs 50,000 of tax benefit. This is well suited for investors who have already exhausted their Section 80C option of Rs 1,50,000. However, NPS investments are very long term in nature and have to be kept live until your retirement to gain meaningfully. You can consider this as a part of your retirement goal alone and not for other goals. Here again, wait to see if you receive this option from your employer in the near future, in lieu of EPF (regulations to soon come on this). Right now the taxability of the NPS amount when you receive it makes it a bit unattractive. Still, some exposure to equity would still likely provide returns better than EPF or PPF.