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Home > Business > Personal Finance

The best way to save tax

February 09, 2006 14:10 IST

The last quarter of the financial year is devoted to an activity, which perhaps is as important as any annual ritual. Yes, we are talking about tax planning; an activity on which most investors spend very little time. Most of us simply invest in line with what we have been doing over the past.

But this year, things are going to be different. A lot more time will have to be dedicated to the tax-planning exercise. And rightly so, because there is a lot more at stake! To put it another way, there is a lot more for you to gain this year!

Until the previous year, tax benefits related to investments in select instruments were defined under Section 88 of the Income Tax Act. Under Section 88, individuals could benefit from a 'rebate' on an investment amount that could not exceed Rs 100,000.

Of this investment limit, Rs 30,000 was exclusively reserved for Infrastructure Bonds (the popularity of this instrument has vexed us for years given the very poor tax-adjusted rate of return). The other part of this investment pie (Rs 70,000) could be invested in a range of instruments including life insurance, National Savings Certificate (NSC), Public Provident Fund (PPF) and tax-saving mutual funds. The investment in tax-saving funds was capped at Rs 10,000 per year.

Save Tax, Save a Life

If this kind of inflexibility was not enough, the 'rebate' was offered in a graded manner to most (not all) taxpayers (Refer Table). If you were earning over Rs 500,000 per year, you got no rebate at all!

Section 88 rebates
Annual IncomeTax Rebate
Upto Rs 150,00020%
Rs 150,000 to Rs 500,00015%
Over Rs 500,000Nil

The finance minister has scrapped Section 88 and introduced a new section, 80C. This section has redefined the way you can plan your taxes. To start with, the inflexibility has been removed. Now there is a Rs 100,000 limit and you are free to invest in any proportion in the approved investments.

Only in case of PPF is the upper limit capped at Rs 70,000. Also, this section offers a 'deduction' benefit as against a 'rebate.'

What this means is that the Rs 100,000 that you save in the specified instruments is 'deducted' from your income; therefore the tax benefit that you are eligible for is equivalent to the tax rate that you pay. For example, if you are in the 30% tax bracket, then your tax savings will be Rs 30,000 (Rs 100,000 * 30%). Furthermore, Section 80C covers all taxpayers. God bless the finance minister!

New income tax structure
Net Taxable IncomeTax Rate
Upto Rs 100,000Nil
Rs 100,001 to Rs 150,00010%
Rs 150,001 to Rs 250,00020%
Above Rs 250,00030%

The net result -- you stand to benefit a lot more. Therefore, you must 'invest' more time in finalising your tax-planning investments this financial year.

The plan to invest for tax-saving should be driven by two objectives. One, to minimise the tax liability. And, two, to complement your existing investments in a manner that helps you meet your financial goals and objectives. It is important to note that tax planning is not an independent exercise. In fact it is an integral part of your overall financial planning.

Asset Allocation for tax-saving instruments

The key to achieving your financial goals is to first define an 'asset allocation plan' that suits your profile, needs and objectives/expectations. If you are, for example, planning for a need say 3 years down the line, then you will have a specific asset allocation. Conversely, the asset allocation to plan for a need 3 months down the line will be entirely different.

Any asset allocation plan has to be made in line with your risk profile. If you are capable of taking on additional risk, to earn higher returns, then you need to take higher exposure to assets like equity shares and vice-a-versa.

Of course, it needs to be kept in mind that the instrument you are investing in has a matching investment horizon. In case of equity shares (in this instance tax-saving funds), it is three to five years; in case of NSC, the maturity is 6 years. So the instruments will need to coincide with your profile and investment tenure.

The other critical component to building an asset allocation plan is a clear objective/goal (or expectation). Once you are clear in what you wish to achieve with your money, it becomes a lot easier to allocate assets. To take an example of how things go wrong, many a time investors park funds in say infrastructure bonds (3 year maturity) when they really need the money only 10 years down the line.

The result is that you are invested in an instrument which gives you a post-tax return of no more than 5% pa even though you could have earned a lot more by simply matching the instrument you invest in to your need (tax-saving funds would probably generate a tax-free return of 12% over this period of time; of course the near term volatility is something that you should be able to absorb).

A more diversified portfolio of assets (which also save you tax) can be planned to ensure that over 10 years you generate a much higher tax-adjusted return as compared to the infrastructure bonds.

Each instrument, which is covered under Section 80C, has its positives and negatives. However, what emerges is that there are sufficient options available today to plan your Section 80C investments in a manner that helps you achieve your financial goals and get a tax benefit to boot.

Comparative analysis of tax-saving schemes
ParticularsPPFNSCELSSInfrastructure Bonds
Tenure (years)15633
Min. investment (Rs)5001005005,000
Max. investment (Rs)70,000100,000100,000100,000
Safety/RatingHighestHighestHigh RiskAA/AAA
Return (CAGR)8.008.0012.00 - 15.005.50 - 6.00
Interest frequencyCompounded annuallyCompounded half yearlyNo assured dividends/returnsOptions available
Taxation of interestTax freeTaxableDividend & capital gains tax freeTaxable

Let's see what an ideal asset allocation plan for tax-saving instruments could look like for individuals based on their age brackets. The basic assumption here is that as individuals age, their appetite for risk reduces. The objective here is to build long-term portfolios that deliver optimal risk adjusted returns.

Recommended asset allocation
AgeLife insurance premiumEPFPPF / NSCELSSTotal
< 30 10,00020,00020,00050,000100,000
30 - 4510,00030,00025,00035,000100,000
45 - 5510,00035,00030,00025,000100,000
> 5510,000- 65,00025,000100,000

A quick glance at the table and it is immediately evident that we do not recommend that individuals go overboard with life insurance as a saving option. Life insurance, in its pure form (term plans) is a must in every portfolio; it is also the most affordable. The allocation should, to start with, be only to that extent.

Over a period of time however, if you are sufficiently exposed to other tax-saving asset classes you could consider adding ULIPs to your portfolio.

The Employee's Provident Fund contribution is really linked to your salary and not in your control (it is mandatory by law). Therefore as you progress in your career your contribution to the EPF will increase.

The PPF is a very popular saving avenue. However, one must remember that the returns in this scheme are not fixed i.e. they are reset every year. So while today you may be parking your funds in PPF at 8% pa, the rate could stand reduced to say 5% pa 5 years down the line. Since the scheme has a tenure of 15 years, you will have no option but to remain invested in the same.

Having said that, the PPF is still attractive because of the tax benefits associated with it (the interest received is also tax free). In fact, if your PPF account is nearing maturity you should increase your annual contribution. Otherwise, it is best to invest only a portion of your Rs 70,000 limit in the scheme.

The NSC, which has a 6 year maturity, scores over the PPF as the rate of return is locked over the period of investment. However, the interest earned from the NSC is taxable.

Finally, we have tax-saving funds (or ELSS -- Equity Lined Savings Scheme). In our view, for investment horizons that are in excess of three years, investors with appetite for risk, must park some portion of their funds in tax-saving funds.

Currently, both dividends and capital gains earned from tax-saving funds are tax-free. This increases the attractiveness of these schemes. However, as appetite for risk reduces, contribution to the tax-saving funds should decline.

A well-defined asset allocation plan for tax-saving instruments will help you realise not just your tax-planning objective, but also complement your overall financial planning. And given the flexibility and benefits that have been introduced this year, you should definitely spend more time on ensuring that your money works for you!

The 2006 guide to Tax Planning. Download the complete guide today! Click here!

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Number of User Comments: 4

Sub: Really good

The information is really useful. Now, I have a better idea of how to invest Thanks a lot.

Posted by Vishal

Sub: Download

Topic is well drafted & well presented. But unfortunately could'nt download Tax planning 2006

Posted by Akash

Sub: 80C benefits

dear sirs, it is not very clear if investments in pension funds up to a limit of Rs.1 lac will qualify for tax deduction. the ...

Posted by kk murthy

Sub: My tax saving plan is best.

$:)I got 30% bonus on investment, :)+additionally I saved 30% income tax, last year,in my tax-saving plan. I never got 60%pa richer ever before. :)Not ...

Posted by gift4free



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