Fenil's Library

Long-term equity can give you better returns than other avenues are no different from regular ones

Sandeep Shanbag

Most taxpayers approach their tax-saving investments with the sole objective of saving tax for the current year. As long as investing in the chosen instrument results in getting tax deduction, their immediate purpose is solved. The instrument of choice is more often than not something recommended by a colleague or promoted heavily in the media. And if you are in senior management or a businessman, then you have already been anointed as an HNI (high net worth individual) and assigned a 'relationship manager' whose sole purpose in life is to force-feed you the latest flavours of the season. The result of this is, at the end of the day, you end up tax saving but not tax planning. 

If you think about it, your tax-saving investments are actually no different than regular investments. The Rs 1-lakh deduction under Section 80C is available in respect of investments made in bank fixed deposits (FDs), post office deposits, senior citizens saving scheme, Public Provident Fund (PPF), insurance and mutual funds etc. These are the very investments that one anyway makes and therefore they need to be integrated into the larger picture in line with one's risk profiles and financial goals. 

Take for example ELSS (equity-linked saving schemes) or tax saving mutual funds as they are popularly known as. From being all the rage till last year, this time around, investors have been avoiding ELSS and choosing guaranteed return products even for tax-saving investments. However, here's another perspective. No one will argue that equity presents the best option for building wealth over the long term. The problem is no one wants to undertake the risk of capital loss over the short term for the sake of appreciation over the long term. 

But let's take a step back and think about it. Say you are in the 31% tax bracket (30% + 3% education cess). Now what this means is that the moment you invest Rs 1 lakh in an ELSS fund, you automatically get a return of 31%. Putting it differently, you will not have to pay tax of Rs 31,000 due to your investment of Rs 1 lakh. In other words, you have earned Rs 31,000 the moment you invest Rs 1 lakh. 

So the capital loss, if any, will only take place if the market (and your investment along with) were to fall by over 31% hereon. As I write this, the Sensex is at 9039. A 31% fall from here would mean a Sensex level of 6237. Therefore, if and only if the Sensex were to fall to a level below 6237 will you actually incur a capital loss. On the other hand, over the next three years, the possibility of the market recovering -- if not to the peak level of 21,000 but at least to a level higher than the present 9039 is more plausible than the other way around. And if this happens, your return would obviously be higher than 31%. 

Now, the 31% tax saving translates into an immediate return but any ELSS investment has to be held for at least three years. So, the correct way of looking at this will be to spread the 31% over three years. This would assume that the market remains flat throughout, neither does it fall nor does it rise. In such a case, the rate of return for a person in the 31% tax bracket would be 13% and that for a person in the 34% tax bracket would be 14.9% p.a. tax-free. 

Perhaps your immediate reaction to the above argument would be that this 31% yield due to tax saving is not limited to an ELSS investment only -- one can get the same benefit from any investment that saves taxes like say PPF, bank FDs, or any of the other instruments enumerated earlier. Quite true. However, at this point I will like to take you back to the fact that over the long term, equity has the potential of delivering the highest return. So, say over a five-year period, an ELSS fund will almost certainly give you a much better return than Bank FD or post office deposit.

During an economic downturn like this one, money becomes tighter. Take the case of Ravi, a friend of mine, who is into web design. Ravi's lament was that he was paying tax on income that he had not received. He had over Rs 5 lakh in receivables but customers in general were holding out for higher credit periods. Since our income tax law taxes income on accrual and not on receipt, he had to pay the tax on the Rs 5 lakh not yet received. He was finding it difficult in arranging funds required to pay his employees for the month, so to keep anything aside for tax saving was a long shot. 

In such cases, one can use another tax planning tool. I call it recycling. Ravi can simply withdraw an earlier investment (say from ELSS or PPF) and redeposit the money, even in the very same instrument. He will get the tax deduction for no additional outlay - in other words, his savings remain the same, but without investing a rupee, he can avail himself of the 31% tax saving.

Tax saving is not an end in itself; it is the means to an end. So, this year don't get seduced by the latest investment product in fashion but instead review your financial goals and asset allocation and then select the tax saving instrument accordingly.