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Stop investing to save taxes. Instead, invest tax-efficiently to meet your life goals. In this article, we explain how you should exhaust your Section 80C limit to meet your investment objectives.
Asset location
Every year, after accounting for your provident fund contribution, you, perhaps, pay life insurance premium to exhaust the Section 80C limit to save taxes. You should instead align your Section 80C investments to meet your life goals. How? For any life goal, you need to invest in equity and bonds. Suppose you have to invest ₹6 lakh this year to meet your life goals. Further suppose that you decide to allocate ₹4 lakh to equity and ₹2 lakh to bonds.
Asset location refers to the process by which you decide how much of the ₹2 lakh to invest in tax-exempt bonds (PPF, EPF and voluntary PF (VPF)) and taxable bonds (recurring and fixed deposits), and how much of the ₹4 lakh to invest in regular equity funds and equity-linked savings schemes (ELSS).
Your bond investments are set up to earn only interest income. So, they fall into tax-exempt investments (no taxes) and taxable investments. We assume that you pay 30 per cent tax on your interest income. Both regular equity funds and ELSSes are meant to generate capital appreciation. If you hold your equity investments for more than a year, you have to pay 10 per cent capital gains tax for gains realised in excess of ₹1 lakh. So, both investments attract 10 per cent capital gains tax when you realise your investment gains in excess of ₹1 lakh . ELSS has a lock-in of three years, though.
Before we discuss further, we urge you to exhaust the Section 80C limit without considering your life insurance premiums. Why? Life insurance protects your family from loss of income after your lifetime. You should, therefore, buy insurance whether you receive tax benefit or not. Also, note that you are allowed to invest up to ₹1.5 lakh annually in PPF and up to 100 per cent of your basic salary, including dearness allowance, in VPF.
Sheltering bonds
So, how should you make your asset location decision?
One option is to exhaust your entire bond allocation of ₹2 lakh using tax-exempt bonds — PPF and EPF/VPF. Here, your interest income on the ₹2 lakh will be tax-exempt, though you can claim only ₹1.5-lakh deduction for your investments under Section 80C.
Your equity allocation of ₹4 lakh can be in regular equity funds or ELSS. However, since PPF and EPF/VPF are long -term instruments, if you need more liquidity, you may have to invest some part of the ₹2 lakh in FDs where interest is taxable. Thus, you could divide your investments between equity and tax-exempt/taxable bonds in several ways depending on the time-frame for your goals and liquidity needs.
So, what combination of equity and debt will increase the post-tax expected return of your portfolio? Assuming an expected return of 12 per cent on equity and 8 per cent on bonds, the post-tax expected return works out to 10.8 per cent on equity and 5.6 per cent on taxable bonds. Our conclusion? You need to shelter your bond investments from taxes. This is true for all asset allocation — ranging from 10 per cent equity to even 90 per cent equity. Why?
Whether you invest in ELSS or regular equity funds, you pay 10 per cent capital gains tax when you sell your investments to meet your life goals. But if you do not shelter your bond investments, you pay 30 per cent taxes. In addition, the difference in expected returns between equity and bonds is large. This argument is further supported by the exemption of ₹1 lakh in capital gains when you sell your equity investments in any year. The upshot? You should exhaust the maximum annual investment limits of PPF and EPF/VPF.
Remember this: you will receive a tax deduction of ₹1.5 lakh every year whether you invest in ELSS or in tax-exempt bonds. But your choice between the two will affect the post-tax returns of your goal-based portfolios. Also, note that you won’t be sacrificing equity returns by not investing in ELSS; you earn such returns through regular equity funds.
The author is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in
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