Thinkinvestor. Protecting bonds from taxes

Previously, in this column, we discussed why protecting your bond investments from taxes is more optimal than protecting equity investments.

That is, investing in public provident fund (PPF) under Section 80C of the Income-tax Act instead of investing in Equity Linked Savings Scheme (ELSS) could improve post-tax returns. Most reader queries that followed since have argued that ELSS is preferable because of higher expected returns than PPF. In this article, we discuss how to choose tax-savings investments.

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Tax location

Suppose you decide to invest ₹5 lakh this year to achieve your life goals. Further, suppose your asset allocation is 60 per cent equity and 40% bonds. You have three tax locations to fulfill your asset allocation requirement.

The first location has taxable investments. This is where your bond investments will be located; your bond investments will earn interest income and will be taxed at your marginal tax rate.

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The second location has tax-deferred investments. Your equity investments will be located here, as tax on capital gains is due only when you sell your investments. And, finally, the third location has tax-exempt investments. This is where your provident fund and PPF will be located.

Now, the tax on your bond investments is higher than the tax on your equity investments. It is, therefore, optimal to use the tax-exempt location for your bond allocation, provided the investments match your life goals. For instance, if you are saving to make a down payment to buy a house in four years, the tax-exempt location may not be optimal. This is because the time horizon for PPF is initially 15 years and does not align with the time horizon for the goal.

But PPF aligns with your retirement portfolio, as you can renew the investment each time for a block of five years till you retire.

Conclusion

Most individuals argue that ELSS offers higher expected returns and gets ₹1.5 lakh tax deduction. The point is that equity investments fall under the second tax location, whether you invest in regular equity funds or in ELSS; you must pay long-term capital gains tax when you sell the investments.

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Importantly, you will be able to claim ₹1.5 lakh tax benefit whether you invest in ELSS or PPF under Section 80C of the Income-tax Act. Therefore, to achieve tax-efficient asset allocation, you must consider shifting your bond investments from first tax location to the third location, subject to the investments aligning with your life goals.

(The author offers training programme for individuals to manage their personal investments)

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