Personal finances and Tax

Why Tax Sops?

The government gives a variety of tax sops to encourage certain behavior. For instance, the tax savings under section 80 c gives tax benefits for savings up to Rs 1.5 Lakh per year. The idea is to get people to save and invest money. Similarly section 80 ccg gives tax benefits for investments of up to Rs 25,000 for people having income less than 12 Lakhs. The idea is to get small investors to invest in mutual funds so that they get good returns without inordinate risks.

Of course, sometimes the tax sops stop making sense. For instance, on a first self occupied house, a maximum of Rs 1,50,000 deduction is available. But on second or more houses, the deduction available is the entire interest less 70% of deemed rent. In the present scenario, with high interest, high property values and low rents, this second option may be several times the first limit. In other words, it gives very high deduction for people buying a second or more property which does not make sense.

Tax Sops and Financial Planning

While good financial planning takes maximum advantage of the tax benefits, it is not directed by tax benefits only. Good financial plans begin with the needs of the individual and once these can be fulfilled, the optimum tax benefit is taken. Often, however, people make mistakes which can be very costly.

For instance, most of the investment options under section 80 c require the investor to lock in the money 5 years. Schemes like NSC give returns of 8.5% but the interest is taxable. So even considering the initial tax savings, net returns are between 9% and 15% depending on the tax slab. Given that most personal loans and EMI schemes are at 14% to 16% interest rates, this is usually a losing proposition.

Of course, investment in PPF is way better because the interest income is also tax free. But since these are very illiquid (and early withdrawal is again taxed),  one needs to think carefully before investing in them.

Rules of thumb

If you are in the 10% tax bracket, then do not invest in tax saving schemes like traditional insurance and NSCs. If you are very certain that you will need money for 20-25 years, then invest in PPF.

If you are in the 30% tax bracket then you should completely meet the limit in section 80 c. Most of it will probably be covered by EPF and similar instruments. Also, you should not require to buy things (except house) on EMI.

If you are in the 20% tax bracket, then the difference between the two options are not significant. But if you do anticipate need for money in a couple of years, then it is better to not invest in locked up schemes.