Plan your taxes well before EET rolls in
With December already here, it's time to start one's tax planning exercise.
Actually, 'tax planning" is a term picked up for clever marketing by issuers of expensive financial products. As far as the average investor is concerned, 'tax planning' for the most part just comes down to the selection of the best Sec 80C product that is available and investing the `1 lakh therein.
Let me simplify the exercise even more. First, let's take into account mandatory payments like provident fund, housing loan EMIs and tuition fees, if applicable. Reduce these from the `1 lakh limit. Invest the balance in public provident fund (PPF). Done and dusted. That's your tax planning exercise. (Readers may be aware that for the current financial year (FY '11-'12), PPF interest has been increased to 8.6% per annum. Also, the investment limit has been increased from the erstwhile `70,000 to `1 lakh.
Now, the issue with PPF is that the interest rate is now market linked - it's no longer fixed for the entire term of the instrument. For example, the 8.6% rate is on offer just for this year. Next year, it will be different and will depend upon the then existing interest rate environment. And so on for the future.
So, if interest rates were to drop in the coming years, then PPF could well yield much lower - one can never say.
If this interest rate uncertainty makes an investor nervous, then the next best option is the tax saving bank fixed deposit (FD). Here you can lock-in interest rate regardless of the external environment. I suggest the tax saving bank FDs in spite of the fact that these offer a rate that is prima facie lower (around 9%) than their plain vanilla counterparts (general FDs that don't offer Sec 80C tax deduction), which can even go up to 10.5% to 11% pa. Though the nominal return from a tax saving FD, per se, seems low, the real effective rate is much higher. In case of individuals who fall in the 30% tax bracket, the effective return is as high as 14.15% pa!
This is primarily because of the tax deduction. Remember that you save tax on the initial investment. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place.
For example, let us assume that an individual deposits `1 lakh in a fixed deposit under section (u/s) 80C and he is in the 30% tax bracket. What this means is that because of his investment, his tax outgo will be lower by Rs. 30,000 (Rs 1 lakh x 30%). Or, in other words, he will be receiving an interest of `9,000 (9% of `1 lakh) on an outlay of just `70,000 (Rs 1 lakh -Rs 30,000). This, as we shall see, jacks up the effective return. Consider the table.
It is assumed that a deposit of `1 lakh is made on January 1 2012. The deposit matures after five years that is, on 31st December 2016. Interest is payable @9% on an annual basis. The depositor has opted for the reinvestment of interest option and hence the interest is not paid out and accumulates. The second column specifies the interest earned every year, the third column contains the post tax interest and the last column contains the cumulative deposit figure for each year.
This is very similar to National Savings Certificate (NSC VIII) as far as the structure is concerned. In case of NSC VIII the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence, it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest should also be eligible for a tax deduction under Section 80C as it is in case of NSC VIII.
However, since there is no clarification from the tax authorities on this issue, in the example, the interest is treated as fully taxable.
An initial investment of `70,000 (as explained earlier), grows to an after-tax `1,35,727. Consequently, the effective return works out to be 14.15% p a. This is for the 30% tax slab. For the 10% and 20% tax slab, the return works out to be 16.08% pa and 15.12% pa respectively! These numbers should make even those investors who reject fixed income investments for potentially higher returning equity oriented products sit up and take notice. Because, this is like saving tax and getting paid for it.
At a time when there is a dearth of good fixed income avenues to invest in, the tax saving fixed deposit with its high effective rate could prove to be extremely useful for the fixed income allocation in your portfolio. However, this window will be open only till such time that the New Direct Tax Code (DTC) is introduced. As of now, it is scheduled to be operational with effect from April 2012 but there is a chance that the date may be postponed. In any case, under the DTC, the Exempt Exempt Taxed (EET) system of taxation would be applicable on any fresh investment in this instrument.
For those who are new to the concept of EET, it is a tax system where an investment in a tax saving plan is deductible from income. So also is the interest earned. However the maturity amount is taxable. The tax saving FD has such a high effective rate since there is a tax deduction available at the front end (invested amount); however, the maturity amount (the back end) is completely tax-free.
Under EET, the maturity amount will be taxable rendering the effective rate equal to the coupon rate of 9% (post tax 6.3% pa). However, so long as the initial investment has been made before the advent of DTC, the maturity amount will continue to be tax-free even in the DTC regime.
So do make hay when the sun shines.
With December already here, it's time to start one's tax planning exercise.
Actually, 'tax planning" is a term picked up for clever marketing by issuers of expensive financial products. As far as the average investor is concerned, 'tax planning' for the most part just comes down to the selection of the best Sec 80C product that is available and investing the `1 lakh therein.
Let me simplify the exercise even more. First, let's take into account mandatory payments like provident fund, housing loan EMIs and tuition fees, if applicable. Reduce these from the `1 lakh limit. Invest the balance in public provident fund (PPF). Done and dusted. That's your tax planning exercise. (Readers may be aware that for the current financial year (FY '11-'12), PPF interest has been increased to 8.6% per annum. Also, the investment limit has been increased from the erstwhile `70,000 to `1 lakh.
Now, the issue with PPF is that the interest rate is now market linked - it's no longer fixed for the entire term of the instrument. For example, the 8.6% rate is on offer just for this year. Next year, it will be different and will depend upon the then existing interest rate environment. And so on for the future.
So, if interest rates were to drop in the coming years, then PPF could well yield much lower - one can never say.
If this interest rate uncertainty makes an investor nervous, then the next best option is the tax saving bank fixed deposit (FD). Here you can lock-in interest rate regardless of the external environment. I suggest the tax saving bank FDs in spite of the fact that these offer a rate that is prima facie lower (around 9%) than their plain vanilla counterparts (general FDs that don't offer Sec 80C tax deduction), which can even go up to 10.5% to 11% pa. Though the nominal return from a tax saving FD, per se, seems low, the real effective rate is much higher. In case of individuals who fall in the 30% tax bracket, the effective return is as high as 14.15% pa!
This is primarily because of the tax deduction. Remember that you save tax on the initial investment. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place.
For example, let us assume that an individual deposits `1 lakh in a fixed deposit under section (u/s) 80C and he is in the 30% tax bracket. What this means is that because of his investment, his tax outgo will be lower by Rs. 30,000 (Rs 1 lakh x 30%). Or, in other words, he will be receiving an interest of `9,000 (9% of `1 lakh) on an outlay of just `70,000 (Rs 1 lakh -Rs 30,000). This, as we shall see, jacks up the effective return. Consider the table.
It is assumed that a deposit of `1 lakh is made on January 1 2012. The deposit matures after five years that is, on 31st December 2016. Interest is payable @9% on an annual basis. The depositor has opted for the reinvestment of interest option and hence the interest is not paid out and accumulates. The second column specifies the interest earned every year, the third column contains the post tax interest and the last column contains the cumulative deposit figure for each year.
This is very similar to National Savings Certificate (NSC VIII) as far as the structure is concerned. In case of NSC VIII the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence, it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest should also be eligible for a tax deduction under Section 80C as it is in case of NSC VIII.
However, since there is no clarification from the tax authorities on this issue, in the example, the interest is treated as fully taxable.
An initial investment of `70,000 (as explained earlier), grows to an after-tax `1,35,727. Consequently, the effective return works out to be 14.15% p a. This is for the 30% tax slab. For the 10% and 20% tax slab, the return works out to be 16.08% pa and 15.12% pa respectively! These numbers should make even those investors who reject fixed income investments for potentially higher returning equity oriented products sit up and take notice. Because, this is like saving tax and getting paid for it.
At a time when there is a dearth of good fixed income avenues to invest in, the tax saving fixed deposit with its high effective rate could prove to be extremely useful for the fixed income allocation in your portfolio. However, this window will be open only till such time that the New Direct Tax Code (DTC) is introduced. As of now, it is scheduled to be operational with effect from April 2012 but there is a chance that the date may be postponed. In any case, under the DTC, the Exempt Exempt Taxed (EET) system of taxation would be applicable on any fresh investment in this instrument.
For those who are new to the concept of EET, it is a tax system where an investment in a tax saving plan is deductible from income. So also is the interest earned. However the maturity amount is taxable. The tax saving FD has such a high effective rate since there is a tax deduction available at the front end (invested amount); however, the maturity amount (the back end) is completely tax-free.
Under EET, the maturity amount will be taxable rendering the effective rate equal to the coupon rate of 9% (post tax 6.3% pa). However, so long as the initial investment has been made before the advent of DTC, the maturity amount will continue to be tax-free even in the DTC regime.
So do make hay when the sun shines.
No comments:
Post a Comment