Porfolio Ideas. Why bond with tax-efficient investments

You should make tax-efficient investments, as you have to meet your life goals only with post-tax investment cash flows; paying higher taxes needs you to save more to achieve your goals. Here we discuss how you can create tax-efficient portfolios.

Tax-advantaged investments refer to those that offer tax benefits. Investments, such as Public Provident Fund (PPF) and Equity-Linked Savings Scheme (ELSS) lower your taxable salary; they qualify as eligible investments under Section 80C of the Income Tax Act. Others such as tax-free bonds offer tax exemption on the interest income.

You should choose tax-advantaged investments wisely, as Section 80C imposes a cap of ₹1.5 lakh a year. Your objective should be to improve your portfolio’s post-tax return as the following example illustrates.

Suppose you need ₹10 crore in your retirement portfolio 30 years hence. You have to save approximately ₹44,000 a month if the expected post-tax portfolio return is 10 per cent. If the expected return declines to 9 per cent, the required savings increases to approximately ₹54,000 a month — about a fourth more than your original contribution!

So, how should you exhaust your Section 80C benefit based on the current tax structure?

Suppose the expected pre-tax return on equity and bonds is 12 per cent and 8 per cent respectively, you should place all your bond investments in tax-advantaged vehicles. Why?

As a retail investor, your source of returns on bonds is interest income, as you will hold your bond investments till maturity. In contrast, your primary source of returns from equity is capital appreciation. The expected return from capital appreciation on equity is higher than the expected income return from bonds. Besides, the current tax structure favours equity investments.

Dividends on equity investments are exempt from tax. Also, capital gains on equity are exempt from tax if you hold it for more than one year. On the other hand, interest income on bonds is taxed at your marginal tax rate. Investing in tax-advantaged bonds reduces this tax disadvantage.

After exhausting the Section 80C limit, invest in bonds that offer tax-exemption on interest income to meet your annual bond allocation requirement.

Why? Taxes saved on interest income will improve your portfolio’s post-tax returns and reduce the required monthly savings.

But what if the government were to impose long-term capital gains tax on equity? Using different amounts towards yearly provident fund (PF) contribution, we found that you should place your bond investments in tax-advantaged vehicles if your PF contribution is more than ₹20,000 a year.

Your PF contribution, eligible for deduction under Section 80C, also forms part of your annual bond allocation. Interestingly, as long as your PF or PPF contribution is above ₹20,000 a year, you should prefer tax-advantaged bonds even if equity is taxed at 30 per cent.

Based on the current tax regime, a portfolio (of ₹5 lakh with 60:40 equity-bond allocation and expected return as mentioned above) with tax-advantaged bond investments will generate higher post-tax cash flows than a portfolio with taxable bond investments.

The excess return attributed to tax-efficient investments is the expected tax alpha.

For this purpose, we have assumed that you will exhaust your Section 80C limit with bonds, including your PF contribution with the spillover annual bond allocation invested in taxable bonds, or you will invest fully in tax-advantaged equity after making your PF or PPF contributions. You can generate tax alpha through tax-advantaged bond investments even if your portfolio has 30:70 equity-bond allocation; such a conservative portfolio will be appropriate if you are within five years from your retirement.

Remember, money saved through tax-efficient investments is cash flow earned for meeting your life goals.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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