Do not let tax saving dictate the choice of financial instrument

Select an option because it is a good fit in your financial plan and will help you achieve your goals

The end of the financial year is the time when individuals scramble to complete their taxsaving investments. Often the main consideration for selecting a particular investment is the tax-saving benefit that comes with it. This can have negative consequences at a later date and is best avoided. Look at an instrument's features in totality — risk, return, tax benefits and liquidity — before deciding to invest in it.

Investing in insurance to meet 80C requirement: One of the most common ways through which individuals meet their Section 80C limit, where the deduction is ~150,000, is through payment of insurance premium. The thinking is that in addition to the tax deduction, the insurance policy will give them the benefit of a life cover. Besides, if it is a traditional plan or unit-linked investment plan (Ulip), it will also provide returns.

This line of thinking often lands taxpayers in financial difficulties. While this year’s tax deduction is one thing, the insurance policy imposes a burden on them to keep investing in the policy for many years. This financial burden can affect their cash flows each year.

It could well happen that you may not require the tax deduction from premium payment after a few years. Other instruments may suffice to meet the limit. Thus, the key reason for buying the instrument could go for a toss. But the premiums would still have to be paid. The best way to tackle such a situation is to buy a policy only if it meets your financial requirements, and not just to meet the current year's tax deduction limit.

Contribution to NPS: The National Pension System (NPS), which is essentially a retirement product, has also emerged as a popular tax-saving tool. Under Section 80C, individuals can avail of a deduction of up to ~150,000 by investing in specified instruments like Employees' Provident Fund, Public Provident Fund, etc. They can also contribute to NPS to get this benefit. An additional deduction of ~50,000 is available for contribution only to the NPS. It is this extra tax benefit that drives many people to put money in NPS.

However, investing in this instrument only to save tax can land you in difficulties. The NPS locks up your money for a lengthy period of time, until retirement, which could be decades away. You will not be able to access these funds. In addition, there would be the recurring responsibility to contribute a minimum ~1,000 each year to keep the account alive. Since this is a retirement planning tool, the conditions under which NPS allows early withdrawals are fairly restrictive. You can only make early withdrawals for specific purposes like medical emergencies, marriage expenses, child's education, etc. Invest in NPS only when the goal is to build a corpus for retirement, and when you are reasonably sure of not requiring these funds in the interim period.

Tax arbitrage: Sometimes, an individual's investment decision is prompted by the desire to enjoy the benefit of tax arbitrage. One example could be the decision to invest in an insurance policy like Ulip as proceeds from it are tax free. Long-term capital gains from equity-oriented mutual funds, which were earlier exempt from tax, will now be taxed at 10 per cent. This kind of arbitrage is not permanent and could change, leaving the investor with an investment option that he does not want.

Earlier, many investors bought equity-oriented investments just because the capital gains on them became tax free after a year.

If their portfolio requirement demanded a debt exposure but they chose equity for the tax benefit, then they could find themselves in a spot of bother. Not only have the longterm capital gains from equities become taxable, this very decision in the Budget has triggered a market correction. If the investor needs his money anytime soon, there is a high possibility that he could end up with losses.

The best way to decide such issues is to stick to your financial plan, and invest in a variety of instruments like equities, fixed income and gold, as dictated by the plan, rather than being swayed by tax considerations.

Avoiding TDS: Many individuals are obsessed with avoiding tax deduction at source (TDS) on investments like fixed deposits. The law states that if you earn more than ~10,000 in interest income from a bank during a financial year, the latter has to deduct tax at source. Many people try to avoid TDS by depositing money in multiple banks to avoid breaching this limit. This has little meaning. If the amounts are small, then undertaking so much effort in depositing money in different banks is not worth the trouble. Anyway, any amount earned as interest from bank deposits is taxable in the hands of individuals. Whether or not tax is deducted at source does not change the nature of taxation of the income. So just trying to avoid TDS does not have any big impact on the tax front, though it does increase the investor's work load. The smarter thing to do is to spend less time and effort on breaking up your investments, and instead focus on claiming the amount back as refund if the deduction exceeds your tax liability.

Buying a house on loan to save tax: Repayment of home loan entitles the borrower to a deduction of ~200,000 a year on interest repaid. Many people decide to buy a house on loan just to avail of this benefit. This is not the right way to go about the whole process and can lead to financial problems.

The purchase of a house entails many additional expenses, such as payment of property tax, monthly maintenance charge to the society, and a variety of expenses on the upkeep of the house itself. In addition, there is the burden of equated monthly instalments (EMIs) which can dent an individual's cash flows and cause a liquidity crunch.

The ultimate impact is that just to save a few thousand rupees in tax, taxpayers end up committing to pay several times this amount, especially in the case of a big-ticket purchase like a house. Purchase a house only if you need one to live in and have the income to pay the EMIs without difficulty.