We do this every year around this time – the more organized ones (or the ones who are forced to be more organized by their employers) start a little earlier, perhaps; but by January, we’re definitely starting to think about how to save tax.
The government dangles carrots: invest in this, that or the other and hey, you get to save tax! We’re suckers for this.
So, we take out insurance policies we don’t need; we make tiny investments galore; we squirrel away little bits of money under this rock and in that tree.
Are we being sensible squirrels or are we letting our visceral hatred for being taxed lead us up the garden path?
Firstly, how do you save taxes via investments? Primarily, hide under Section 80C which allows you to deduct a maximum of Rs.100,000 from your income provided you’ve invested that much in one or more of the carrots. Among them are the Provident Fund, the Public Provident Fund, life insurance policies, pension funds, National Savings Certificates, occasional infrastructure bonds, post office deposits, senior citizens savings schemes, equity linked savings schemes… quite a smorgasbord of carrot delicacies.
But remember, if you want to start tucking into all those carrots, you’re still going to run into that overall ceiling of Rs.100,000 – the maximum you can deduct from your income.
Secondly, there are the occasional additional section 80-whatevers, like the currently popular one, 80CCF, which promises you a maximum deduction of Rs.20,000 from your taxable income if you invest that much in specific bonds.
Let’s look at this latest, very popular, one in more detail. The bonds are issued by a single company (L&T, IDFC, etc.), carry interest at 9%, can’t be redeemed for at least 5 years and mature in 10 years.
Investment in these bonds gives you a max Rs.20k deduction from your income. That’s important – it’s not Rs.20k less tax, but Rs.20k less income that gets taxed. So, if you’re in, say, the 30% tax bracket (which is the highest one), you will save a maximum of 30% of Rs.20k which is Rs.6,000. So, to save Rs.6,000 you lock up Rs.20,000. And because Rs.20k is the max deduction, you only invest Rs.20k – no point locking up more, right?
Now, the bonds earn interest at 9%, which is taxable. Again, if you’re in the 30% tax bracket, this means your effective interest is 9% less 30% tax which is 6.3%.
On the other hand, if you were to park this money in say, PPF, you would earn 8.6% and this is currently tax free. If the new Direct Taxes Code comes into effect, you would pay tax on this interest but only in the year in which you withdraw it, which would be 15 years away, so you’ve postponed taxation for 15 years (and you could keep postponing by extending the PPF till you retire).
The difference between 8.6% and 6.3% is 2.3%, which means by investing that Rs.20k in PPF rather than in the bonds, over 10 years you would earn 2.3% X 20k X 10years = Rs.4.6k extra – this is interest you’re foregoing by investing in the bonds rather than in PPF.
So, by investing in the bonds, your actual saving is the Rs.6k tax minus the Rs.4.6k incremental interest you forego = Rs.1.4k, which is the cost of a movie for you and 3 buddies at a multiplex.
For this paltry sum, you are fragmenting your investment portfolio into a small chunk of Rs.20k, and taking a punt on a single company’s fortunes (L&T or IDFC or whoever) for a decade (or at least 5 years) with no option to pull out.
In our opinion, the pay off is just not worth the hassle.
We always advise against fragmenting your portfolio.
If you have an investment of Rs.20,000, even if it doubles in value, it’s still a gain of only Rs.20,000. However, if you have a single investment of say, Rs.2,50,000, then even a 10% appreciation earns you Rs.25,000 and a 10% appreciation in a single investment is a lot more likely to happen than a 100% appreciation particularly across lots of little ones. This is why we always urge for a meaningful or ‘material’ investment strategy.
In this case, we’d say pay the Rs.6k tax and invest the available balance of Rs.14k in your existing equity portfolio: that has a good chance of growing 10% annually over the next 10 years – entirely tax-free.
Which is not to say, don’t invest in the carrots provided by 80C. Some of those carrots are pretty delicious – PPF, being a case in point. Just don’t do it for the wrong reasons, like saving tax.