The tax-saving season is round the corner. Are you still running around to finalize tax-saving investments? Well, there are so many ways to save tax. There is PPF, EPF, NPS, ELSS, LIC policies, ULIPs, 5-year FDs, life and health insurance plans, pension plans and many more.
In this post, I do not intend to discuss the merits and demerits of specific products. Or which is the best tax-saving product? I just want to discuss how you should approach the selection of tax-saving products this season. Here is a quick checklist.
#1 Your Tax-Savings Will Vary Depending on Your Tax Bracket
If you are in 30% tax bracket, tax-saving investment of Rs 1.5 lacs will help you save tax of 45,000 (before cess). For an investor in 10%, the same investment will result in tax-saving of only Rs 15,000. I understand that “only” is subjective. Rs 15,000 may mean different to different people. However, not everyone saves 46,000 by investing Rs 1.5 lacs in ELSS or ULIPs as highlighted in advertisements.
#2 Consider Automatic Tax-Savings Too
- Your contribution to your EPF account counts towards Section 80C limit of Rs 1.5 lacs.
- The tuition fee that you pay for your children’s education counts towards Section 80C limit.
- The principal repaid during the year on your housing loan is eligible too.
- The premium payment for the LIC policy which you have been running for the last 15 years counts too.
Hence, count all such investments and figure out how much you need to invest to bridge the gap. For instance, if you have already put in Rs 1 lac, you just need to invest Rs 50,000 more to maximize the limit. Any excess amount (over Rs 1.5 lacs) that you invest in such products does not help you save any tax.
Then, you have expenses outside tax-saving investments that help saves taxes. Examples: Interest payment on your housing loan, Health Insurance premium, house rent (if you stay on rent and get HRA), leave travel allowance, etc. All these expenses reduce your taxable income and might bring you under a lower tax bracket. As we have seen earlier, as you move into a lower tax bracket, the tax-savings will reduce.
#3 Don’t Be so Selfish
Insurance planning is the first pillar of financial planning. You must have adequate life, health, and disability coverage. A term insurance plan is the best and the cheapest way to buy life insurance. The premium is eligible for tax benefit under Section 80C. Health insurance premium is eligible for tax benefit under Section 80D.
But many of us do not look at these products for tax-saving since such products may not pay anything back. For instance, if you survive the policy term of a term life plan, you will not get anything back.
However, think about your family too. What if something happens to you? How will your family manage the finances if you were not around? A term life insurance plan will help here. What if a family member gets hospitalized for 30 days? Wouldn’t you want to provide the best quality treatment to your family? A health insurance plan will help here. Therefore, buying life and health insurance plans are the best tax-saving decisions you will make.
#4 Various Tax-Saving Products Have Different Lock-in Periods
Equity-linked savings schemes (ELSS or tax-saving mutual funds) are equity products and have a lock-in period of 3 years. You are not required to invest every year. On the other hand, ULIPs have a lock-in of 5 years. PPF investments have a lock-in of 15 years. NPS investments are locked in (almost) until the investor attains the age of 60.
Moreover, how lock-in periods are treated varies across products.
- In ELSS, each installment (investment) is locked in for 3 years.
- In ULIPs, the first year premium is locked in for 5 years. Second year premium is locked-in for 4 years. The premiums paid after the 5th year face no lock-in period.
- PPF is quite similar too. The investment made in the first year is locked-in for 15 years. The investments made in the subsequent years face shorter lock-in periods. For instance, the investment made in the 14th year will be locked in for just 1 year.
#5 Invest According to Your Risk Profile
ELSS is a pure equity product. PPF is a pure debt product. ULIPs can be pure equity, pure debt, or hybrid products. Equity products can be very volatile but offer prospect of high returns. Debt products offer stable returns, but the return potential may not be high. When you are choosing a tax-saving product, it is important to pick a product that is suited to your risk appetite.
#6 Consider the Commitments and Exit Penalties
This is a big problem with insurance and investment combo products. Usually, you do not pay premium for just one year. You must pay the premium for many years. So, this becomes a recurring commitment. You need to see if you can afford such a commitment.
Let us consider an example. You buy a traditional life insurance plan. The annual premium is Rs 1 lac, and the premium payment term is 10 years. The same annual premium must be paid for 10 years. What happens if you do not pay? If you realize later (after paying the first premium) that you bought a wrong product or cannot afford the premium (and do not pay any further premiums), you may have to forfeit the premium paid i.e., all the money gone down the drain.
Moreover, the tax benefits (availed in the previous years) will be reversed. Yes, that is true. If you do not pay an annual premium for at least 2 years in a traditional life insurance plan or for at least 5 years in ULIP, the tax benefit will be reversed.
With traditional plans, even if you stop paying the premiums after a few years and exit, you will have to incur heavy exit penalty. That is usually not the case with other tax-saving products.
You are advised to keep such aspects in mind when you are selecting your tax-saving investments. A short list of Do’s and Don’ts.
Do’s and Don’ts of Tax Planning
- Do not rush and pick investments without understanding the product properly. Such mistakes can happen with traditional life insurance plans and ULIPs because these can be difficult to understand.
- That is why it is important that you plan much in advance. Do not leave such investments for the month of March.
- Consider your risk profile. You do not go for fancy tax-saving products. If you have a low-risk appetite, even a 5-year tax-saving fixed deposit is a fine choice.
- Consider lock-in periods and payment commitments.
- Consider asset allocation. For instance, if your asset allocation strategy requires you to put money in equity products, you can pick ELSS. If the strategy requires you to divert money towards fixed income investments, you can pick PPF.
- You do not have to save every possible penny of tax. Do not let your tax saving urges to hold your investments hostage. Many investors make poor investment choices just to save tax. Choose investments that are aligned with your financial goals (or planning). If such investments also help you save taxes, that is just an additional benefit.