Buy tax-exempt bonds

It is that time of the year when most individuals get busy stashing away their savings into tax-exempt investments. In this article, we explain how you should optimally choose such tax-savings products.

Investment allocation

We ask you to set aside the compelling urge to save taxes! Instead, first decide on how much you want to allocate to equity and bonds based on your investment objectives. By bonds, we mean your investments in bank fixed deposits, Public Provident Fund (PPF), Provident Fund (PF), bond mutual funds and other interest-bearing instruments.

Your decision to allocate between equity and bonds is a function of two variables- your investment horizon and your ability to assume risk. Consider investment horizon. Invest in equity only if you have an investment horizon of more than 5 years. You can allocate more to equity as you increase your investment horizon beyond 5 years. Likewise, your equity allocation can be higher if you have greater ability to assume risk. Your ability to take risk, in turn, is a function of your age, income and your savings potential.

Suppose you have decided to invest, say, 55 per cent in equity and 45 per cent in bonds for your retirement portfolio. This is called your asset allocation decision. Your choice of tax-exempt equity or bonds should be aligned with your asset allocation decision. That is, the tax-exempt products you buy should be a step in fulfilling your asset allocation decision, not just an action to save taxes.

Tax-savings allocation

Most individuals typically buy more tax-exempt equity than bonds. We explain below why you should consider bonds as part of your tax-exempt investments.

One, tax-exempt equity products such as Equity Linked Savings Scheme (ELSS) require you to hold the investment for three years. But if you hold equity for more than one year, long-term capital gains are tax-exempt. So, why invest in products that can offer you tax savings anyway?

Two, given the reason stated above, you should consider tax-exempt bonds. This includes investment in PPF and PF. Such products also offer tax-exempt interest during the life of the investment. Moreover, withdrawal of investments at maturity is also tax-free. Stated another way, post-tax returns on bonds are lower, as bond investments are taxable, unlike equity investments. So, take advantage of investing in tax-exempt bonds to fulfil your asset allocation decision.

Three, your benefit of investing in tax-exempt products is Rs 30,000 on an investment of Rs 1 lakh, assuming marginal tax rate of 30 per cent. We want you to think of this as subsidy that you receive from the government each year for investing Rs 1 lakh. You will receive this subsidy whether you invest in tax-exempt equity or bonds. You should nevertheless choose tax-exempt bonds because they increase your post-tax returns.

The amount you invest in tax-exempt products is based on your contribution to your PF, which is essentially a non-discretionary investment. Below, we provide easy-to-follow process to plan your tax investments:

One, calculate the insurance amount you require to cover your mortality risk. Buy term insurance and not investment-linked insurance products.

Two, calculate the available room for further tax investments by deducting Rs 1 lakh from your insurance premiums and contributions to PF. Invest in PPF to exhaust this limit. Begin investing from April of a financial year to enjoy the benefits of compound interest.

Three, consider New Pension Scheme (NPS) if you have the available room and do not want to exhaust your PPF limit.

(The author is the founder of Navera Consulting, a firm that offers wealthmapping and investor-learning solutions. He can be reached at enhancek@gmail.com )

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