labels: finance - general, investment - general, mutual funds
Saving taxes with mutual benefitsnews
The one big change that
13 April 2005

Dr Uma Shashikant*, vice president, knowledge management, Prudential ICICI AMC Ltd, offers a simple investment and tax planning strategy

The one big change that will remarkably alter the long term wealth of investors is the tax concession to equity linked savings schemes. Traditionally, in order to save tax, one invested in certain specific schemes, most of which were interest bearing, fixed return bonds. The interest rate on these instruments has been reducing over the years, making these investments an inappropriate choice for long-term investment for financial goals like retirement.

Though it was well known that equity investments enable growth and offer a hedge over inflation, they were not part of the long term tax advantage savings that most investors make every year. This budget enables investment in equity upto Rs. 1,00,000 through tax saving plans of mutual funds.

What difference can equity make to a portfolio? Consider table I below, that shows the growth in the value of investment made in various avenues five years ago. Table 2: Value of Rs100 invested on April 1, 2000 in various instruments

Instrument

Rate of Return

Investment on April 1, 2000

Value of investment on March 15, 2005

PPF

11%

100

167.7847

POSD

10.50%

100

164.0701

Bank

12%

100

175.4153

MIS

11%

100

167.7847

KVP

12.25%

100

177.3656

IVP

13.43%

100

186.8059

44NSC

11.83%

100

174.0989

Equity Tax Saving Scheme

19.66%

100

245.3234

All rates of return are from the Reserve Bank of India's Handbook of Statistics on Indian Economy, 2000. Some of these instruments are not liquid at the end of five years, so the value is only indicative.

Let's concentrate on the returns on equity-linked saving schemes (ELSS) pertaining to the average of the top five ELSS schemes. No loads have been considered in the computation. Past returns may or may not be sustained in the future.

Tax benefits are available to investors either on the amount of investment made, or on the income earned from their investments, or both. There are essentially three types of tax benefits on investments - an exemption, a deduction and a rebate. An exemption means that you need not pay any tax on such income. A deduction means that the income received on the investment can be deducted (usually upto a certain limit) from the taxable income. A rebate means your income tax is computed and rebate on specific investment is reduced from the income tax payable.

For each kind of investment option, the tax benefit was earlier defined in terms of these three categories. For example, section 88 of the Income Tax Act provided a list of investments, and investing a stated amount in each one of them, provided the investor the benefit of a rebate. Similarly, Section 80L of the Income Tax Act allowed certain categories of incomes like the interest on 'post office monthly income scheme' (MIS), to be deducted from taxable income. This budget has changed these tax benefits completely.

Section 88 and 80L no longer apply. A new section 80C has been introduced, which provides a deduction of Rs1,00,000 from the taxable income, for all individuals and HUFs, for investments in a list of schemes provided under that section. There are no instrument-wise limits under section 80C. However, the interest income from investments will now become taxable, unless they are specifically exempt from tax. This alters the relative attractiveness of investment instruments as you can see in table II:Table 2: Relative attractiveness of tax saving instruments

Instruments

Tax Status of income/dividend

Tax benefit on investment

PPF

Exempt

80C*

Tax Saving Schemes of Mutual Funds

Exempt

80C

Equity oriented schemes of mutual funds

Exempt

None

Debt schemes of mutual funds

Exempt**

None

Equity Shares

Exempt***

None

Contribution to Provident Fund

Exempt

80C

Company Debentures

Taxable

None

Bank Deposits

Taxable

None

Post Office Deposits

Taxable

None

National Saving Certificates

Taxable

80C

KVP and other Saving Certificates

Taxable

None

RBI Relief Bond

Taxable

None

Senior Citizen Bond

Taxable

None

Post Office MIS

Taxable

None

Company Deposit

Taxable

None

Infrastructure Bonds of Financial Institutions

Taxable

80C

* Maximum Limit of Rs70,000 per annum applies. ** Subject to dividend distribution tax of 12.5 per cent for individuals and HUFs and 20 per cent for others. *** Subject to dividend distribution tax at 10 per cent

As you can see, fixed return instruments like POSD, term deposit and MIS have become less attractive today because the income is taxable. On the other hand, investments in equity funds under the tax saving scheme is more attractive as investment is tax deductible and dividends are tax free.

In planning your investments in the new regime consider the following:

  • Earlier, only those investors with a gross total income below Rs5 lakh, were eligible for a rebate under section 88. Now they can make these investments, and enjoy a deduction, too, from their taxable income upto Rs1 lakh every year.
  • Investors can choose their saving instrument. Earlier Rs10,000 was the maximum amount the investor can invest in a tax saving scheme of a mutual fund, to get the rebate under section 88. Now this investment can go upto Rs100,000. Among the list of instruments available for investment, the investors can choose their allocation according to their needs and preferences.
  • Investors earned a higher effective income in those instruments that were eligible for deduction under earlier section 80L. They now have to pay tax on these incomes, which in turn reduces the effective return on these instruments.

The tax saving schemes of mutual funds compare very well and offer a good investment choice. They offer a triple benefit - higher returns, exempt income, and tax benefit on investment under section 80C. The relative attractiveness of equity investments have never been better for the ordinary investor.

*The author is vice president, knowledge management, Prudential ICICI AMC Ltd.


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Saving taxes with mutual benefits