The importance of tax-planning

The importance of tax-planning

For most individuals tax is a four-letter word. How many individuals willingly part with their hard-earned money for taxes? Not many! Mention paying taxes and all those age-old arguments about - "what do we get that we should pay taxes?" surface. While that is a topic which can be debated for eons, few would dispute the utility that tax-planning can offer.

What is tax-planning?

Tax-planning amounts to making investments or contributions in line with prescribed guidelines that lead to reduction in tax liability. Simply put, the tax liability is computed as a percentage of the income. As per prevailing tax laws, certain investments and contributions have been earmarked for claiming tax benefits. When these investments and/or contributions are made, the same are reduced from the income while computing the tax liability. As a result, the tax liability is reduced. No marks for guessing that lower taxes are a welcome break.

Section 80C

Now that we have discussed what tax-planning is, the next step is to discuss how the same should be conducted. Before that, an introduction to Section 80C is necessary. While there are a number of sections in the Income Tax Act that offer opportunities for tax-planning, the most popular and pervasive one is Section 80C. You can claim deductions under Section 80C for a variety of investments - for example investments in tax-saving funds (ELSS), Public Provident Fund (PPF), National Savings Certificate (NSC), infrastructure bonds and tax-saving fixed deposits. Similarly, contributions towards provident fund, life insurance premium, repayment of the principal amount on a home loan, payment of tuition fees are also eligible for Section 80C deductions.

How tax-planning can lead to wealth creation

The Section 80C limit has been set at Rs 100,000 in a financial year. This means you can invest upto Rs 100,000 every year in the stipulated investment avenues or utilise the sum for paying life insurance premium, repaying a home loan and claim tax benefits. Now the same has a two-pronged effect. First, you save tax at present, and second, by investing the monies, you are creating an asset/income for the future. For example, investments in tax-saving funds, PPF and NSC will yield returns in the future. Life insurance premium repayment will mean that your dependents will be provided for in your absence. Finally, home loan repayment will lead to creation of an asset (a housing property).

Let's not forget that we are talking about investing Rs 100,000 (which is a significant sum) every year. Simple maths tell us that Rs 100,000 invested every year at 8.0% per annum (pa) over a 15-Yr period will amount to a substantial Rs 2,715,200.

How to create wealth

Now that we have discussed tax-planning, its benefits and how it can help create wealth, let's come to the interesting part - how to create wealth. We discuss some of the major investment avenues that offer Section 80C benefits and should form a part of your tax-planning portfolio.

1. Tax-saving mutual funds

Tax-saving mutual funds (also called equity linked savings schemes - ELSS) are equity funds that offer tax benefits under Section 80C. Essentially, like equity funds, these funds also invest their corpus in equities. However, the differentiating factor is the 3-Yr lock-in and the tax benefits. While in a regular equity fund, the investor is free to sell his investment whenever he wishes to, in a tax-saving fund, the investor must stay invested at least for a 3-Yr period. Also, investments in a regular equity fund aren't eligible for any tax benefits, but investments in tax-saving funds are eligible for Section 80C tax benefits.

For a young investor like you who has time on his side, tax-saving funds should be the preferred tax-planning destination. They will aptly match your risk appetite.

2. Public Provident Fund

Public Provident Fund (PPF) is an assured return scheme (i.e. it offers guaranteed returns) that runs over a 15-Yr period. The scheme requires recurring investments i.e. annual investments are necessary to keep the PPF account active. The minimum and maximum investment amounts are Rs 500 and Rs 70,000 respectively pa. Investments in PPF are eligible for Section 80C deductions. Also the interest income from PPF is tax-free.

At present investments in PPF offer a return of 8.0% pa, compounded annually. However, this rate is subject to revision; hence, investments in PPF may yield a higher or lower return going forward, depending on how rates are revised.

You can make smaller contributions to the PPF account. The same will help you build a risk-free corpus for the future.

3. National Savings Certificate

National Savings Certificate (NSC) is another assured return scheme. However unlike PPF, it isn't recurring in nature. Hence, an investor is required to make a lumpsum investment that matures after 6 years. The minimum investment amount is Rs 100, while there is no upper limit for investing in NSC. Interest income from NSC is paid on maturity; the same is also taxable. Interest accrued on NSC is considered to be reinvested; hence, it is eligible for reinvestment under Section 80C.

Investments in NSC offer a return of 8.0% pa, compounded half-yearly. This rate is locked-in at the time of making the investment. Hence investment is insulated from any subsequent rate change.

You can make investments in NSC for a 6-Yr period to gainfully invest one-time surpluses and to provide for needs that will arise over a corresponding time frame.

4. Tax-saving fixed deposits

You must be aware of fixed deposits offered by banks. Tax-saving fixed deposits aren't very different. These are fixed deposits, wherein investments upto Rs 100,000 are eligible for deduction under Section 80C. Generally, Rs 100 is the minimum investment amount. Tax-saving fixed deposits have a 5-Yr investment tenure and no premature withdrawals are permitted.

At present, most banks offer a rate of return in the range of 8.0%-8.5% pa. A higher rate of return (additional 0.5%) is offered on investments made by senior citizens. Also the interest income from tax-saving fixed deposits is chargeable to tax and subject to TDS (tax deduction at source).

Tax-saving fixed deposits can be utilised like NSC, to meet future needs that will arise over a predictable period.

5. Unit linked insurance plans

Unit linked insurance plans (ULIPs) are the most "happening" offerings from the life insurance segment. Simply put, ULIPs are market-linked avenues that combine insurance and investment. Premiums paid on ULIPs are eligible for deduction under Section 80C. ULIPs have been dealt with in detail in another article in this guide.

In conclusion, remember that tax-planning is not just another dreary chore that has to be conducted annually. On the contrary, it's an opportunity for wealth creation. Give the tax-planning exercise its fair attention and time.