Portfolio ideas. Want to save tax? Go for bonds

This is the time of the year when you start thinking about your income tax and how to cut down on it.

But be careful not to invest only to save taxes. Your primary objective should be to achieve your goals.

The first step is to decide how much to invest in equity and bonds. This is asset allocation. You may, for instance, decide to invest 70 per cent in equity and 30 per cent in bonds to meet your retirement needs. The next step is to identify products to fulfil this allocation.

Based on the current tax regime, you should first choose tax-efficient bonds to exhaust your annual tax exemption limits. Investing in public provident fund and voluntary provident fund, besides your regular provident fund contribution, should take priority. Why choose fixed-income options first?

Long-term capital gains tax and dividends received on equity investment are already tax-exempt.

On the other hand, both interest and capital appreciation on bonds are taxable. Interest income is taxed at your marginal tax rate whereas capital gain is taxed at a lower rate.

The primary purpose of your long-term investments is to beat inflation.

To ensure that your bonds too beat inflation, it is necessary to go for tax-efficient ones. Therefore, invest in special bonds that offer tax benefit on interest income. Tax-free bonds issued in the past by public sector companies are a case in point.

Their interest is tax-free though they attract capital gains tax if sold in the secondary market.

While there is no foreseeable new issue of such bonds, you can still buy them from the secondary market. Such bonds are best held till maturity.

What if the government changes the tax laws for equity investments?

We suggest you still do your tax planning with bond investments.

Suppose the expected annual return on equity is 15 per cent and that on bonds is 9 per cent.

Even if equity were taxed at the same rate as bonds, your post-tax return on equity would still be higher.

If you invest in assets or products other than equity and bonds, ensure that your total investment is not spread over a long time period.

This is because tax laws could change adversely at a later date. You could face a similar problem if the government were to tax, say, public provident fund (PPF) withdrawals. Your choice of tax-efficient investments boil down to a simple rule: After accounting for your term insurance premium, exhaust your annual exemption limit by first investing in tax-efficient bonds.

Note that you have to anyway invest in equity funds and bank fixed deposits to meet your goals.

So, changes in tax laws that make these products less attractive should not affect your investment decision.

Finally, remember: Your objective is not to choose investments that save taxes. Instead, choose tax-efficient investments that help achieve your goals.

The writer is the founder of Navera Consulting. Feedback may be sent to portfolioideas@thehindu.co.in

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