The season of your Human resources department asking you for declarations regarding your income tax return filing has arrived this year. So, before you commit, invest and declare your money in various tax saving options, we would suggest you read this blog post and then decide. If you have already decided and executed this year’s tax-saving investments, then it’s never too late to start thinking about the next year’s tax planning.
This blogpost tries to define tax planning and how to efficiently execute it with various tax saving investment options available in India.
Tax planning is an upgraded version of your every year tax return filing activity with your CA which also includes managing the investments related to your tax profile. Tax planning has become a necessary part of our Financial Planning activity.
We strongly advocate the practice of filing Income Tax returns every year by every earning individual even if they do not cross the tax-free bracket in our country. Conventional tax filing has been an exercise for individuals to file their Income Tax returns and pay their taxes. In our current modern economy, the government and the income tax department are being very proactive in tracking our income tax returns and linking it to every aspect of our financial life like loans, credit scores, leasing, etc. For this reason, tax planning has become a very critical aspect of an individual’s finances every year to efficiently save taxes while filing income tax returns.
Tax planning should optimize your tax bill by using various investment options that are suitable to your needs and profile. When it comes to properly plan your taxes for every financial year, the choice, timing and profile of the investments are very important.
Let us take a micro example of a salaried individual aged 30 years and earning 70,000 a month. Most of us already know that we have a section 80c that enables us to invest in various investment options and claim a tax deduction that reduces our tax bill. Rather than exploring options in the last quarter of the financial year (Jan – Mar), when we get a call from our HR to declare their investments, this activity can be planned well ahead in the financial year and can be well efficient and effective.
Tax planning and investment planning go hand in hand as we use some investments to save taxes and we pay taxes on some investments. Either way one cannot live without the other.
We not only need a CA but also a certified investment advisor when it comes to tax planning.
Investments / Expenses that can reduce our taxable income
There are three major and basic investments or expenses that many of us earning individuals have.
- House Rent Allowance
- Medical Insurance
- 80C investments
We talk about HRA (house rent allowance) because most of the cases we can claim it in various legal ways as long as we do not own a house on our name. If we own a house on our name, then it is very difficult to claim HRA deduction on our income.
Medical insurance in major tier 1 and tier 2 cities has become a new necessity with the ever-increasing medical costs and financial burden of medical emergencies.
The 80C puzzle
There are various options available to save your taxes by reducing our taxable income. Taxable income is the final income on which the government makes us pay an income tax. The lesser the taxable income, the lesser tax we end up paying.
Section 80C of our income tax is the most popular investment vehicle to reduce our taxable income.
The limit under this section per year is Rs. 1,50,000 (National Pension Scheme has an additional Rs. 50,000 benefit limit per year).
The major relatable investment options under 80C are:
- Employee contribution towards PF (Provident fund)
- Public Provident Fund Contribution
- Life Insurance Premium
- Equity Linked Savings Scheme (ELSS)
- Unit Linked Insurance Plans (ULIP)
- Principal Repayment on our Home loan
- Children’s tuition fee
- National Pension Scheme (NPS)
- Post Office / Government / Bank FD Saving Schemes
Some of these options are natural and relatable parts of many of our financial profiles.
A homeowner with a home loan in tier 1 or 2 cities will have a pretty sizable EMI and after the first few years, most of the EMI goes towards principal repayment. The principal part of the EMI can be claimed as a tax deduction under 80C
Couples with children pay tuition fees for their education and that amount can be claimed as a tax deduction under 80C
Many companies mandate Employee Provident Fund contributions as a part of our salary which can be claimed as a tax deduction under 80C
Life Insurance is a basic financial necessity for us if we do not want our family members to miss us financially. Our life insurance premiums can be claimed as a tax deduction under 80C
Most of us have one or all of these in our financial profiles. We can only claim Rs. 1,50,000 in total as a tax deduction under 80C. So, if the above-mentioned four necessity investments cross the magical Rs. 1,50,000 number then we have very little scope of tax planning to be done by us to reduce our tax bill.
Tax planning to reduce our tax bill will have greater significance if the above-mentioned four necessity investments do not reach the Rs. 1,50,000 limits under 80C.
Efficient Tax Saving via Tax Planning
High efficiency is driven by making the right and suitable choices. Making suitable investment choices to reduce our taxable income requires more than usual care because of the liquidity factor. We believe that there are two major factors driving the degree of suitability in choosing tax-saving investments:
- Liquidity or the lock-in time of that investment
- The risk profile of the investment
Liquidity and Risk Profile of 80C Investment options
Liquidity is an important aspect of any investment as it gives the flexibility and freedom of using our money in the best suitable and adaptable way.
The risk profile of an investment shows us the possibilities of investment loss (losing our initial investment). The risk profile is very important while checking the suitability of an investment as some of us prefer high predictability which is low risk versus less predictability which is high risk.
Let us consider the main investment options under 80C other than the four options that we discussed earlier and are more of a necessity than a choice.
Money-back Insurance policies or Unit Linked Insurance Policies are two very similar products but marketed in a different way with technical differences. They both have a minimum of five years lock-in with very strict policies of liquidity. The cost of investment is high (average money back policy first year agent commission is 30% and ULIP commission is 5% of the amount invested). They definitely have decent risk exposure in the form of equity capital markets as their underlying investments based on our choices. Equity exposure is needed to beat the normal bank FD rates or inflation in general.
So, money-back insurance policies have weak liquidity and decent risk exposure with limited risk-reward opportunities.
We believe that no one below the age of 40 or 45 should have any exposure to either money-back insurance policies or ULIP’s as they can get a term insurance policy for an affordable price giving greater coverage.
Provident Fund or NPS are very different when it comes to the risk profile of these investments. Provident fund is backed by the government but has a fixed return based on the RBI interest rates. National Pension Scheme is backed by the government but has a portfolio manager that takes some level of equity market exposure based on the plan we choose (choice of plan is very crucial).
The liquidity aspect of both these schemes is very weak. They have high lock-in periods with very little scope of using those funds if needed in future. The adaptability is very rigid in these investments.
While employee contribution towards Provident fund gives many of us decent exposure to a government-backed investment, we feel there is no need to increase that allocation as there are better alternatives in liquidity and risk profiles.
Tax Saving Bank Fixed Deposits, Government Savings Schemes and Post Office Savings Schemes are excellent investment vehicles when it comes to low-risk profile investments with lesser lock-in periods. The lock-in periods range from five to ten years which is not too high but also not the lowest in the available 80C investment options. The return profile is very limited when we consider inflation and opportunity cost of investing.
These investments can be used as a substitute for other low-risk tax-saving investments like Provident fund or money back insurance because of the liquidity advantage and the reinvestment edge.
Equity Linked Savings Scheme Mutual Fund (ELSS) is a very powerful investment vehicle for a lot of taxpayers when it comes to saving tax as well as gaining exposure to equity capital markets (that have a history of beating inflation) with the lowest lock-in period in the pool of 80C investment options. ELSS having only three years of lock-in period has the highest liquidity and lowest lock-in period among its 80C peers. ELSS has a relatively high-risk profile as it is completely invested in the Indian equity capital markets with exposure to all sized companies (Large, Mid and Small Cap companies). Practically ELSS is a Multi-Cap Equity mutual fund with a three years lock-in time.
Suitable Investments Planning
According to us, a mixture of ELSS and a bank five years tax-saving fixed deposit is best suitable for most of the investors. The degree of suitability is dependent on the allocation and the timing of these investments.
The allocation depends on the age and the personal risk profile of the investor and the timing should be a monthly investment rather than a sudden once a year deposit.
Money-Back Insurance, ULIP, Provident fund, NPS and other non-necessary investments are decent investments but not the best when compared to other 80C investment options.
Financial Planning Case-Study example:
Let us look at the previous example pie graph where there is a high scope of efficient tax saving
Age of the individual – 35
Marital Status – Married
Children in school – Yes (1 child)
Annual Income – Rs. 15,00,000
Home Loan – No (rented house so HRA is claimed)
Balance investment that can be done in other 80C options is Rs. 85,000
For a profile like this, we recommend Rs. 75,000 in ELSS mutual funds and Rs. 10,000 in tax saving bank fixed deposit.
ELSS gives us good exposure to beat inflation and gain equity returns and Employee contribution to provident fund and tax-saving bank FD will reduce risk and reduce the chances of losing capital.
VBS recommended ELSS Funds
Axis Long Term Equity Fund
The fund has a concentrated portfolio with good financial sector holdings. It is a multi-cap fund but high exposure to large-cap growth category stocks. The only thing we don’t like about this fund is its exposure towards power and telecom companies which might end up giving good or bad returns. We believe the portfolio manager who has been doing an excellent job.
Invesco India Tax Plan Direct Growth
This fund complements the Axis fund with more defensive sector exposure like consumer goods companies. The sector distribution is fair and diverse. The fund manager has been a good stock picker and we believe that it will continue in the future.
Mirae Asset Tax Saver Direct Growth
This fund has been doing exceptionally well in recent times, but we do not like this fund because of recency bias. We like the fund manager and the diverse sector allocation. The fund has been doing well because of the good stock picking done by the fund manager.
Coincidentally these were top-rated funds discussed in the recent episode of “The Mutual Fund Show” telecasted by Bloomberg Quint with Vishal Dhawan (Plan Ahead Wealth Advisors) and Nirav Panchmatia (AUM Financial Advisors) as guests talking about the advantages ELSS funds have compared to other investments and which ELSS funds are the best options to invest.
We strongly believe that we cannot predict the moves of any mutual fund portfolio manager in the future because right now we are taking these combinations based on the current allocations of these 3 funds. We do not know if these will be managed the same way in the future. To eliminate this risk, we consider many other metrics that gauge the consistent performance of the portfolio manager and this fund and how do they perform as a combination.
We suggest the combination of these ELSS funds for this year should do the job of having the most efficient portfolio when it comes to a good risk-reward performance of our tax saving investment.
We hope that this blog post has been really helpful to gain more clarity on what the available different options are, and how to choose from the investment options to save your taxes.
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