Real Returns. Three foolish ways to save on taxes

Many investors seem to think that financial planning is synonymous with tax planning.

Much of the time and effort they devote to money matters is spent on addressing only one question — how do I minimise my tax outgo? While this approach can save them a packet on taxes, it may also seriously impede their ability to meet their financial goals.

Would a 65- or 70-year old investor who has retired from service invest in equities? Normally no, because the gyrations of the stock market would have him recoiling in horror.

But thanks to the tax-free status of dividends from equity funds, many retired investors actually do invest in them. Strangely enough in India, the returns from most safe investment options (except the PPF and NSC to some extent) are taxed at high income tax rates, while returns from risky equities are exempt. Therefore, just to reduce their tax outgo or avoid the pain of filing tax returns, many investors end up adding equity funds to their portfolio, though their risk profile does not allow it.

Equity funds in a retired investor’s portfolio can cause considerable damage. For one, their portfolio can suffer capital losses or years of sub-par returns (as it happened between 2007 and 2013) if the stock markets are stuck in a rut. If an emergency crops up during such phases, they may be forced to exit with a capital loss. Two, they may not receive the regular dividends that was budgeted for either. Equity funds pay dividends only out of the realised gains on their portfolio holdings. If the markets are down, the realised gains are likely to be zilch, and the fund may altogether skip dividends.

For such investors, if tax considerations were out of the way, the best course of action would be to go for bank or corporate deposits which can deliver regular income, without risk to the principal. Sticking to a safer asset allocation may not help them save taxes, but it would certainly be a more risk-free way of acheiving their regular income objectives.

If some investors take on too much risk to save taxes, others take on too little, surprisingly for the same reason. They select all their investment options with an eye on tax breaks and, in the process, neglect to check out their returns or suitability.

If someone told you that there was a savings plan that earned a 5 per cent annual return, paid commissions of 5-15 per cent to the agent and required you to write out five-digit cheques for the next 10 or 15 years without knowing where the money was going, would you sign up for it?

But traditional and endowment insurance plans offer precisely these ‘benefits’ and yet hundreds of Indian investors have routinely bought them. The only lure was that they could earn tax exemptions on their premiums.

Thankfully, clarifications to tax laws in recent years have ensured that only insurance plans that offer a life cover of at least 10 times the annual premium are eligible for 80C tax benefits today. Therefore, the only reason for you to buy an insurance plan today is the actual protection it offers against risk to your life.

After putting away ₹1.5 lakh out of their income towards section 80C, many investors have hardly any surplus left to invest in long-term goals such as retirement or medical emergencies.

Therefore, prioritising tax savings over better returns or investment options, they park all their surpluses in 80C investments.

This can be quite injurious to their financial health. The list of investments eligible for section 80C benefits is dominated by low-return earning, extremely passive debt investments.

Typically, most investors will find their 80C limits exhausted after EPF contributions, investments in PPF and NSC, term insurance premiums, and so on. Of these, EPF and PPF returns usually fail to beat inflation and term insurance premia don’t fetch any actual returns.

So, if your annual investment kitty is restricted to 80C investing, you can be sure that you will end up with a sizeable shortfall towards your living expenses when you retire.

This suggests two things. Young investors who are in need of a retirement corpus must look beyond 80C when drafting their annual investment plans. They may need to invest as much in equity and balanced funds (to build a retirement kitty), as they do in 80C options.

But if they can’t manage this, they must first look to put away money towards critical goals such as retirement and only park the remaining sum in 80C. Here, ELSS schemes, which do enjoy 80C benefits, can serve as a supplement to your equity portfolio.

These instances suggest that you should not let tax savings take over your financial decisions. Plan your finances based on asset allocation, return expectations and your risk appetite. If you save taxes in the process, that’s just the icing on the cake.