Deductions under section 80c are either expenses or investments. Blend tax-efficient debt and equity investment options to maximise benefits and balance risk
There’s no dearth of ways to reduce your income tax outgo. Section 80C of the Income Tax Act alone gives you about a dozen options. This section is vital to your taxes as it provides the maximum deduction among all other sections at Rs 150,000 (not including home loan interest, of course!).
So what’s the best option that you should go for? To know that, you need to understand your own finances and the nature of the options before you, and then prioritize.
What’s on offer
Deductions under Section 80C fall in two groups. Expenses – principal payment on home loan, two children’s tuition fee. If you have these, claim these first. The other group is investments – deposits, mutual funds, pension schemes, provident fund schemes – and insurance premia.
Before getting into which option, first figure out how much you should save. Though the limit is Rs 150,000, you may not need to use up this entire amount, especially if you’re in the lower tax slabs and/or if you have permissible expenses, large home loans, and health insurance. Use online calculators to work out how much you need to sock away under Section 80C.
Investments under Section 80C are either fixed-income based, where there is a defined return, and equity-based, where returns depend on stock market movements. Then there’s life insurance. Each instrument has its own pros and cons. The key to optimizing Section 80C deductions is to combine different options to maximise benefits.
First, protection. Do you have a term life insurance policy? If yes, move to the next step. If not, take up a term plan before going for any other option. While there are several types of life insurance policies on offer, a plain vanilla term cover gives you the highest sum assured for the lowest premium. Don’t mix insurance with investment. Policies such as ULIPs, though touting return benefits, offer limited insurance cover for the amount you pay out as premium. One insurance policy will suffice if covered well; it’s not optimal to have multiple life insurance policies.
Next, build up tax-efficient safe options: If you’re not a salaried employee, put away about half your tax-saving investments in public provident fund (PPF). If you are salaried, you would already have an EPF contribution. Don’t go overboard with VPF (where you increase your EPF). By stepping up investments to these instruments, you will be moving almost entirely into fixed-income options. You’ll miss out on better-returning alternatives, and this can have quite an impact on your wealth accumulation (explained further down).
A note about PPF and EPF. While they are interest-bearing instruments, the rate of interest itself changes – each year, for EPF and more frequently for PPF. So while the current rate of PPF at 7.9% and EPF at 8.65% seem attractive, know that they can drop. PPF, for instance, used to be at 8.7-8.8% between 2012-2015. PPF rates have gradually come down over the years and the 10%-plus rates of the 90s are a thing of the past.
Skip all the other fixed-income options on offer – NSC, 5-year bank FD, post-office time deposits. Interest income on all these is taxed, turning their post-tax returns unattractive. For example, current 5-year bank FD rates are about 6.25%. Post tax, these drop to 5.9%, 4.95%, and 4.3% in each tax slab.
Third, add an equity kicker. Invest the remaining half of your available amount in tax-saving mutual funds. These funds invest in equities and therefore, over time, deliver far better than PPF and EPF. Sample this: an investment of Rs 10,000 each year in PPF for the past five years would leave you with Rs 64,890 at the end of March 2019. A similar investment in tax-saving funds would be, on an average, Rs 70, 853. Quality funds such as Axis Long Term Equity would be higher at Rs 75,145. While PPF and tax-saving funds are from different asset classes, the point here is that the long time frame allows you to take the risk to optimise your returns.
Over even longer timeframes, the difference is far higher as equity compounds and delivers better the more you give it time. The same Rs 10,000 invested each year for the past 10 years amounted to Rs 1.63 lakh in PPF and Rs 2.25 lakh on an average in tax-saving funds.
Many investors mix up lock-in period with holding period, for tax-saving funds. Lock-in, which is 3 years for tax-saving funds, is simply the period in which you cannot sell your fund. There’s no maturity value to a tax-saving fund, unlike your FD or NSC. Post the 3-year mark, your ELSS is simply a normal equity fund.
Blending a safe option (PF) with a riskier one (funds) would leave you better off in terms of wealth creation instead of going all-out on a single option.
The confusion between holding period and lock-in period can push you into looking at 3-year returns alone, or exiting in 3 years, while equity funds in general need at least a 5-7 year time frame. Equity can see poor performance even on a 3-year timeframe. The Nifty 50 has delivered losses on a 3-year timeframe 11% of the time since its inception. That’s not an evil; the key is to have a long-term holding period, which is when equity delivers as seen in the example above.
Equity is riskier. But if you can give PF a good decade in holding period, its essential to accord the same discipline to tax-saving funds to tide over the risk and volatility. Blending a safe option (PF) with a riskier one (funds) would leave you better off in terms of wealth creation instead of going all-out on a single option.
Take up specialised schemes if you qualify.
The Senior Citizen Savings scheme should be the first and only option if you are above 60 years of age, since it is unmatched in terms of interest rate. If you are saving up for your daughter’s education, the Sukanya Samriddhi Scheme is a great long-term fixed-income option. Do not shun equity investing because you have this option. Blend them.
Skip options such as mutual fund pension schemes. These have longer lock-in periods and exit loads up to age 60. Should you need the proceeds for an emergency or the fund underperforms, it can be difficult to move. The ELSS-provident fund combination is a better alternative.
Don’t include NPS
Personal (not employer) NPS contributions up to Rs 50,000 are allowed separately under Section 80 CCD in addition to Section 80C. If you want less active approach to markets invest via NPS, under Section 80CCD. Combining the two sections would net you a neat Rs 200,000 deduction in total, assuming you invest Rs 50,000 in NPS.
If you are a government employee or a private employee under corporate NPS, you can optimally mix the options under Section 80C and the NPS to build a tax-efficient portfolio. We’ll cover that in a separate article.
So don’t make your tax-saving decisions all in a hurry. Use this guide and be smart!