The Hindu Business Line : Budget and your investments

The message of the Budget is quite clear. Investment planning with an eye on the tax implication is now more important than ever to secure your finances. It is well recognised that strong economic growth does not automatically translate into returns on financial instruments, as China has found over the past five years.

We may have actually entered an uncertainty-ridden era of low returns and strong inflation. In this regard, the tax breaks on specific instruments/avenues offer investors a unique opportunity to enhance the return on investments. Though the Budget did not tinker much with tax breaks, the approaching financial year is the ideal time to size up the tax breaks.

What's the tax rate?

In total, a taxpayer can enjoy tax-breaks of up to Rs 3.5 lakh — Rs 1 lakh for investments from income, Rs 1.5 lakh for interest payable on housing loan and Rs 1 lakh for contribution to super-annuation. The effective tax incidence for a salaried taxpayer with an annual income of Rs 12,00,000 will be only 15 per cent.

It would also leave such a salaried taxpayer roughly a little over 50 per cent of the annual income for other expenditure — that is about Rs 55,000 a month. Since other expenditure will now not include housing, even if this sum does not allow him to splurge, it will allow him to maintain more than a reasonable standard of living.

For a taxpayer with annual income of Rs 6,00,000, the effective tax rate could dip to below 10 per cent, even without full utilisation of all the tax-breaks. Again, in this case, 60 per cent of the annual income would be available for personal expenditure — working out to about Rs 30,000 a month. It would not be much if you own, or want to own, a car. With this salary, you could probably manage a house only in the suburbs, forcing you to spend considerable time commuting

The tax rates written into the statute do not, as such, appear unreasonable. Salaried taxpayers would also need some support from their employers as it is the latter who can subscribe to a super-annuation policy. If employers do offer that kind of support, it would go a long way in optimally structuring your allocation to taxes, expenditure and investments.

Asset allocation

Of the options available, the investor has the flexibility only to structure the component of Rs 1 lakh that can be invested in various options under Section 80C of the Income-Tax Act. For taxpayers earning higher than Rs 10 lakh, even this flexibility is not available. This is because provident fund contributions and the need to keep alive term insurance policies would have fully subsumed the Rs 1 lakh limit. For salaried taxpayers earning significantly less than Rs 10 lakh, structuring this component will depend on such issues as:

Age and risk preference of the taxpayer;

Status of super-annuation — whether you have a policy and, if so, its investment pattern;

Amount deducted as contribution to your provident fund; and

Amount to be contributed to term assurance policies.In any case, salaried taxpayers with income of about Rs 6,00,000 may not have more than Rs 60,000-70,000 to play with. This is because contribution to provident fund would take away Rs 30,000 and another Rs 5,000-10,000 may be needed for term assurance plans. But even Rs 60,000 invested every year for 20 years can grow to about Rs 34 lakh if the rate of return were about 9 per cent per annum.

This Rs 34 lakh will be apart from the corpus of provident funds, super-annuation and the value of your housing property. That should be enough to take care of most of your needs post-retirement.

So, how should the Rs 60,000 be invested? Typically, if you have a super-annuation policy and it invests mainly in debt instruments, you should use the limit under Section 80C mainly for equity-oriented tax-saving instruments, such as tax-saving equity funds and pension plans.

Insurance, pension plans

Investors would also do well to separate insurance and investments. For insurance, they can consider term assurance plans. We feel that insurance plans, specifically unit-linked plans that mix insurance and investments, offer deals that are not as good as a strategy that mixes mutual funds, pension plans and term assurance plans.

The limit for investment in pension plans has now been hiked to Rs 1 lakh. The limit, till now, had been only Rs 10,000. So, should investors consider investing more in pension plans? They should. The advantage of a pension plan is that it forces you to invest for over 15 years. And people are more likely to view the insurance premium as a necessary expenditure and would perforce keep the policy alive.

One disadvantage of the pension plan is that the income received after maturity in the form of annuity is taxable although one-third of the amount can be commuted tax-free. In contrast, if you made investments in an equity mutual fund for 20 years, you can redeem the sum without any tax incidence.

Though, of course, if the Finance Minister ushers in the Exempt-Exempt Taxable system, the redemption proceeds from future investments in mutual funds will also be taxable.

Keeping these factors in mind, a step-up in allocation to a pension plan, say, from Rs 10,000 to Rs 20,000, appears reasonable. A higher increase is not advisable as investors are locked into pension plans till retirement. This robs investors of the flexibility to change allocation in case the plan they choose under-performs.

Debt instruments

Many investors are piqued that finance ministers in recent times have been nudging investors toward equities. This may, however, be in their interest. For instance, if investors had put Rs 10,000 in tax-saving equity mutual funds every year over the past 10 years, instead of putting all the money in provident funds, small-savings and tax-saving bonds, their wealth would be several times larger.

For those who need to invest in tax-saving debt instruments, voluntary contribution to provident fund should top the list. The rate of interest on employee provident fund is higher than any other debt instrument, and the returns are totally tax-free. There is no better investment option available now. Next would come the public provident fund, which offers 8 per cent tax-free.

Other instruments are not worth considering. This is because income from other instruments, such as National Savings Certificate, Tax Saving Bonds and the term deposits of banks, are taxable.

Tax-saving equity funds

The attractiveness of tax-saving equity funds as wealth-builders has increased in recent years. Almost all the funds have beaten the Sensex over a five-year period. Some, such as HDFC Long-Term Advantage, HDFC Tax Saver and PruICICI Tax Plan, have notched up returns that are twice that of the Sensex. Others, such as Birla Equity Plan, Magnum Tax Gain and Sundaram Tax Saver, have also delivered attractive returns. The returns compare favourably with those from diversified equity funds.

In tax-saving equity funds, the only cause for concern is the rich valuations at which stocks are trading. Systematic investment every month should allow investors to tide over this problem. Also, valuations matter less if the investment horizon is beyond 10 years.

Over such a longer period, notwithstanding the prevailing rich valuations, it is reasonable to expect equities to outperform most asset classes. Investors should not, however, get locked into long-term systematic investment plans. One year at a time is more than enough. This will help them assess the fund's performance and change course, if necessary.

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