Often I have noticed that people want to invest just for the sake of saving taxes. It may not be an ideal attitude towards investing, but for a community which loves to invest only in real estate and gold, there was a need to offer more than just investment returns to divert the investors from their traditional investment approach. And bless the Indian finance minister who introduced these tax saving investment options which reduce the taxable income by an amount a person invests his saving into specified instruments (subject to a cap of Rs. 100,000). In a country which loves to save, this was kicking their investments on an overdrive. The finance minister and Reserve Bank of India would have felt proud of their policy actions as it incentivised and promoted the people to invest in products for their retirements plans.
The essence behind the specific investment options given by the tax man was:
1. Invest in products with a lock in period of minimum 3 years. This was to promote a habit investing for a long term horizon in order to create wealth rather than short term investing to make money.
2. Promote people to get life insurance – as Indians hate to perform what if analysis on the unforeseen situation of their death.
However, corporates businesses had another thing in mind. Who cares for noble motives behind the RBI and the government. Businesses are there to make profits – isnt’ it ?. They brought in multiple products (specially the ULIPs) which were compliant with the tax requirements, but at the same time required investors to invest continually for a long period of time such as 10-15 years. The idea was good – make investment as a compulsion rather than an option. However, the negative aspect was that these investment options were not providing adequate returns – rather making the advisors / agents happy as they got another source to earn fat commission cheques and the businesses to earn charges.
An after maths of all this was that a common man didn’t perform a proper financial planning to strategically service his goals. His goal started and finished with his annual tax planning, which in most cases was irrational and driven by a quick act to save tax before 31 March. The agents on the street were sharp enough to spread a scare / lost opportunity whereby the people were asked to invest quickly in order to save a lot of tax. Alas, the gullible investors committed themselves into a multi year investment obligation which in most cases was an inefficient usage of their capital and did not comply with their long term financial goals.
Changing Tax Slabs
To add more pain to the story, the tax man started reducing the tax rates. You might be wondering why I am calling a reduction in tax slabs as a pain – shouldn’t it be a cheerful news as it would mean more funds in your pay check. Let me explain it with an example. Refer to the table below, you would be happy to see that a person earning 2 lacs was in 20% tax slab in 2005 and the same person with same salary levels in 2012 was in tax free slab.
|Upto 2 lac
|upto 1 lac
|1 lac to 1.5 lac
|1.5. lac to 2.5 lac
|over 10 lac
|over 2.5 lac
If the investment decisions were purely tax driven in 2005 and the person earning 2 lacs invested 1 lac to avoid paying tax for next 10 years, in 2012 his investment decisions won’t serve his main motive of saving tax as he would be in a tax free territory even without investing.
Direct Tax Code – Mother of All Tax Saving Uncertainty
Another biggest looming uncertainty is Direct Tax Code which aims to remove the complete investment driven tax rebates. So if our political system can bring the scheduled DTC from 1 April 2013, all the tax saving investment options such as insurance policies, PPFs, ELSS mutual funds, etc. may loose their biggest driver – tax saving ! So you can very well visualise the tax impact of your investment decisions in the form of multi year insurance policies, ULIPs, etc.
So the next obvious question is – if tax is not the driver of your investment decisions, then what is the right approach ? What should drive your investments ? Where does the tax aspect join the investment horizon ?
The answers to all these questions is perhaps best sorted out by getting a good financial advisor who can help you to get your financial objectives and investments aligned – in the best possible tax efficient manner. The art is to get tax saving while meeting your financial goal, rather than meeting your financial goal while performing your tax planning. A couple of tips which I can give are :
1. Identify your financial goals – say retirement in next 20 years and have a retirement corpus of Rs. 1 crore.
2. Identify your current liabilities & assets and future liabilities.
3. Get an estimate of your current and forecasted future income / cash flows.
4. Identify the investment instruments which are available in the market to help you meet your goal. For each of the instrument you would need to understand the underlying risk, potential returns and the TAX impact.
5. Choose the instruments in line with your requirements – it is here that you should look out for instruments which can provide you the returns in line with your risks but with minimal tax payouts.
6. Execute your plan and monitor them on a yearly basis for any changes in tax regulations.
I hope this article would have made the mark in highlighting that tax saving is a by product of your financial planning. The last section of the article aims to show in a step by step manner how tax planning relates to your financial planning. So if you are still aiming to save some tax via such investments, please do a thorough review of your financial plan and current state analysis of your finances. Based upon it, choose an investment option which both justifies your long term goal and gets you tax saving.