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The less taxing options
N Mahalakshmi in Mumbai
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February 21, 2005 10:42 IST

It is that time of the year when everyone is looking for ways to save taxes. Small savings schemes, infrastructure bonds and insurance policies are among the most popular tax saving investments among marginal tax payers.

Salaried people are also increasingly committing themselves to housing loans in order to save taxes. It is only incidental that they end up owning houses!

Often in the urge to save taxes, people make investment decisions, which are not necessarily the best thing to do.

Over the years, people end up with too many insurance policies. Or much less than what they require. Also, they end up with investments, which deliver sub-optimal returns.

All these years, one could ignore most investment products in favour of government savings schemes as they delivered the best returns, and that too with a guarantee. But now that is changing and you need to revisit your financial plan.

First come, best served

It's never too early to start saving. Because the sooner you start investing, the more your investments will benefit from the power of compounding and tax-deferred growth.

Compounding simply means that, over time, the interest you earn on your original investment (your principal) also earns money. The longer you let your money grow, the more powerful the effect of compounding.

Sample this: If you invest Rs 1000 per month every year starting from the age of 24 till 58 (a total investment of Rs 408,000), you would end up with Rs 1,05,62,041 if your investment earned you a return of 15 per cent per annum. But that kind of return may be difficult to attain for normal investors. Even if we assume a modest 8 per cent return, you would end up with Rs 20,55,801.

Contrast this with another scenario where you start investing late at age 45, but invest Rs 5000 per month (total investment of Rs 8,40,000) you will end up with a much lower amount of Rs 15,61,126.

The power of compounding can also work against you. In the form of costs. Especially in case of mutual funds and unit-linked insurance policies. In our example, if your were to earn only 7 per cent per annum over a 34-year period, 1 per cent being costs, you would be poorer by Rs 4,08,958 at the end of the term.

ULIPs, which bundle insurance and investments together, entail greater transparency than conventional insurance schemes but their cost structure makes them more expensive compared to mutual funds. But for tax concessions, ULIPs do not compare favourably with mutual funds.

Also, ULIPs charge high upfront expenses, unlike mutual funds, which charge uniform expenses throughout. So you need to hold ULIPs much longer for them to deliver better return than mutual funds, even if the investment performance of the two fund managers is the same. Opting out of ULIPs mid-way is costly. Also, you need to remember that greater transparency means more costs, or lower returns in ULIPs.

Buying insurance policies mindlessly to save on taxes is a bad idea. Money-back and endowment policies are the most popular among insurance buyers. Not because they are the best policies but because agents sell these products more aggressively as they get better commissions.

Insurance companies earn more money as they earn asset management fees by managing money and not just for managing mortality risk. Usually, insurance cum investment products work out more expensive than if you buy insurance for the sake of it and invest the rest of the money judiciously elsewhere.

In this issue, we have demystified ULIPs, listed the low cost term plans and introduced equity-linked savings schemes, arguably the best mutual funds category available today. Also, we have listed certain lesser-known provisions pertaining to individuals in the Income-Tax Act.

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