Ever found it difficult to make up your mind at a buffet spread? The braised chicken smells heavenly, so does the grilled fish. The pasta in cheese sauce looks inviting, while the salad bar is choc-a-bloc with interesting options. But one can eat only as much as one's appetite allows, so it is important to be choosy.
Investing to save tax under Section 80C is no different. All the options are good, but suit different investor profiles. “Each tax-planning instrument has a different underlying objective, which needs to be understood by the taxpayer before making an investment,”says Vikas Vasal, executive director, KPMG. Your choice should be defined by your life stage, financial goals and ability to take risks. Identifying the right option is easier if you do not leave tax planning for the last month of the financial year. Sanjay Grover, tax partner, Ernst & amp; Young, advises taxpayers to do a rough calculation of their likely income and savings at the beginning of the financial year and then allocate resources to various options. “A disciplined approach will allow the taxpayer to take a better investment decision,”he says.
Chandigarh-based Prahlad Kumar Wahi knows this too well. The PSU manager is scheduled to retire next year and is concentrating his investments in ultra-safe options such as the EPF and the PPF. For the past several years, he has been investing more than the Rs 1 lakh limit under Section 80C in these two options and his reasoning is simple. “I'm going to retire in 18 months. Safety of the capital is very important for me at this stage,”he says.
Wahi's concerns for safety are justified. A man at the threshold of superannuation cannot afford to invest heavily in volatile assets such as stocks. That's why only 15 per cent of his savings are invested in equity funds and stocks. The rest benefits from the magical power of compounding in his PF and PPF accounts. After he turns 60, he will invest his retiral benefits in the Senior Citizens' Savings Scheme, which also qualifies for Section 80C benefits and earns 9 per cent a year.
Cut to Delhi, where senior consultant Jasneet Bindra's allocation to tax-saving options under Section 80C is a photocopy of Wahi's. Bindra stashes away the maximum permissible Rs 70,000 in her PPF every year, while another Rs 30,000 flows into her PF account. Prudent asset allocation? Hardly. At 30, Bindra is in a position to take higher risk. Her high income level and comfortable financial situation (double income, no kids) also suggest a higher allocation of savings to equity-linked products. Yet, Bindra is grossly under-exposed to the stock markets. Instead of galloping on equity-linked savings schemes (ELSS), her savings are growing at a slow pace in fixedincome options.
Tax planning should not be treated differently from financial planning. The asset allocation rules that govern financial planning should be applied to choosing the most suitable investment option under Section 80C. “The most important thing is to understand the risk-reward ratio. While ELSS products could be volatile over the short run due to market performance, they have the potential to deliver superior returns over the medium to long term,” says Sukumar Rajah, managing director & amp; CIO, Asian Equities, Franklin Templeton Investments.
In the past five years, the ELSS category has delivered annualised returns of 21.7 per cent. The best performing fund during this period, Magnum Taxgain, has earned 31.9 per cent every year on an average. This means that Rs 10,000 invested in the fund on 13 January 2005 is now worth Rs 39,878. That's not all. Even the worst performing ELSS fund managed to beat the fixedincome category by earning 11.2 per cent a year compared with the 8% returns from the PPF and NSCs. Now you know what Bindra is missing.
Any investment should take into account several factors how soon you need the money, your expectations of returns, the risk you are willing to take and the flexibility of the option. Each Section 80C option offers a different combination of these factors (see The Matrix). The PF and pension plans are very safe, but they lock up the money for the long term. NSCs and five-year fixed deposits are also safe and have a shorter lock-in period, but the returns are very low. ELSS funds can give extraordinary returns but come with high risks. Traditional life insurance policies, which are arguably the worst way to save income tax, offer low returns, low flexibility and low risk. Add to this the low risk cover and you will know why endowment and moneyback plans are poor investments.
However, this does not stop taxpayers from flocking to this lowreturn option. Delhi-based software professional Rakesh Ojha, 33, has an endowment life insurance policy and a child plan that gobble up Rs 41,000 in premium every year, while two Ulips account for another Rs 35,000. Though insurance needs are specific to an individual and take into account several factors, such as the existing assets, financial needs and outstanding debts, the rule of thumb is that one should have a life insurance cover of at least 5-6 times one's annual income. However, Ojha is paying Rs 76,000 a year for a life cover of less than 1.5 times his annual income.
He is not only underinsured, but the huge insurance premium prevents him from investing in other options. “After paying the insurance premium, I have very little left to invest in other options,”he rues. Ojha is paying for buying life insurance to save tax on the advice of a friend who sells insurance. “Investing to oblige friends and relatives without studying the returns and suitability of the option is a common mistake,”says Charul Shah, a Mumbai-based financial planner.
Life insurance is a crucial component of financial planning not as an investment, but as a means to cover the risk of death. “The primary aim of a life insurance policy should be to cover risk; earning returns and tax savings can be by-products of investing in such a policy but should never be the primary reasons,”says Neeru Ahuja, tax partner in Deloitte India.
The cheapest form of risk cover is a term insurance policy. Ask Anand Kothari. The 45-year-old PSU manager from Surat has three term plans that cost him Rs 18,000 a year and cover him for Rs 20 lakh, and has another Rs 8 lakh worth of accidental death cover. Considering that he is in the 30 per cent tax bracket, the effective cost of the Rs 28 lakh cover comes to Rs 12,500 a year “I have taken the maximum term for these plans because it may become very costly to buy fresh insurance at a later age,”he says. Kothari repays about Rs 26,000 of his home loan and contributes roughly Rs 42,000 to his PF every year.
Insurance is not the only area where Kothari has got it right. He also invests in ELSS funds but takes care to choose them well. New fund offers don't attract him. Flashy returns are glossed over. Only established funds that demonstrate consistent performance are picked up. This is something that experts also advise. “While performance is an important benchmark, emphasis should be on consistency,”says Sankaran Naren, CIO, equity, ICICI Prudential AMC. The ICICI Prudential Tax Plan managed by Naren has been the best performing ELSS fund in the past one year with 123 per cent returns. Don't go just by its short-term performance. The fund has delivered 27.2 per cent annualised returns since its launch in 1999.
We have shortlisted the six best tax plans for you. Each of these funds suits a different type of equity investor. The Franklin Templeton Taxshield Fund, for instance, has almost 68 per cent of its corpus invested in large-cap stocks that are considered safer than the mid-caps and small-caps, which make up nearly 50 per cent of the portfolio of HDFC Taxsaver. The aggressive allocation reflects in the returns of the two funds. While Franklin Taxshield has grown 37 per cent in the past six months, HDFC Taxsaver has shot up by 45 per cent.
This is not a rat race. Considering a three-year perspective, Franklin Taxshield has outperformed, while over five years, HDFC Taxsaver scores better. So, returns should not be your only guide. The six best ELSS funds have been shortlisted on the basis of consistency of performance, the risk they carry and their potential. Investors should choose the funds by matching their expectations of returns and their ability to take risk.
An effective way to reduce the risk in equity investments is to take the SIP route. It helps in tiding over the volatility that is inherent in equity markets and places investors in a win-win situation. Also, it is advisable not to pack too many ELSS funds in your portfolio. One or two are more than enough.
One drawback of ELSS funds is that you can't touch the investment before the three-year lock-in period. This is not the case with Ulips, where savvy investors can switch from equity to debt and vice versa depending on their reading of the market. This makes a Ulip an excellent asset allocation tool that can be used to rebalance the portfolio whenever required. Ulips also help fulfil an important financial need covering the risk of death of the family's breadwinner.
The latest Irda guidelines on Ulips, which place a cap on the charges to be levied during the term of a plan, have made this Section 80C option more attractive. That does not mean the end of misselling (see Don't Make this Mistake). Tax planning time is open season for unscrupulous brokers who would want to sell you products that suit them more than your financial goals.
Yateesh Srivastava, CMO of Aegon Religare Life Insurance, tells you what to keep in mind when you invest in a Ulip. Read them before you sign on the dotted line.