The middle class tax deduction dilemma

Publication: India Notes

Date of publication: November 30th, 2012

Link: Link to India Notes article

 

Taxes and the middle class

Given that the average 5 year inflation rate is about 9.8% p.a. , India’s tax rates can be considered to be fairly high. If you have any doubts about this, ask any of the 160 million middle class people in India. It is therefore of paramount importance that you legally minimize the amount of tax that you pay. You can do that by taking full advantage of the deductions that the taxman allows. I won’t bore you by describing the dozens of possible deductions that you can claim – this information is easy to find and is just one Google search away. Instead, I want to take you through the dilemmas that people face while considering investments specifically tailored to take advantage of these tax deductions.

 

Investments under Section 80(c)

Unless you have been living in a cave, you probably already know that you are allowed to deduct certain long term investments from your taxable income under Section 80(c). Tax savings from these investments depend on the maximum tax rate that you currently pay which in turn depends on your annual income. Your tax savings from these investments therefore, range from Rs 10,300 to Rs 30,900, depending on your income.

To jog your memory, here is a summary of the various investments that qualify under this section-

Fixed return investments:Employee Provident Fund (EPF) contributions, Public Provident Fund (PPF) contributions, tax saving fixed deposits with lock in periods of 5 years, National Saving Certificates (NSCs) with lock in periods of 6 yearsand life insurance policy premiums.  Returns from these investments are usually fixed and known in advance. They are generally in the range of 7-9% p.a., though this varies from time to time.

Variable return investments: Special mutual funds called ELSS s with lock in periods of 3 years and ULIPs with lock in periods of 5. Returns from these investments depend largely on the performance of the stock markets and to a limited extent, bond markets.

The Dilemma:Investing causes cash flow problems. Should I invest Rs 1 lakh and part with it when my tax outgo only reduces by Rs 10,300-Rs 30,900?

When you invest Rs 1 lakh in tax saving investments, you cannot spend this money today. So, in effect – you are giving up Rs 1 lakh in spending to save between Rs 10,300 and Rs 30,900. As a middle class person who is already hard-pressed for money – this doesn’t seem to make much sense. Right?

Wrong! If your highest tax rate is 30.9%, you are getting a guaranteed return of Rs 30,900 from tax reductions. You are basically getting free money from the government and you would be stupid to give it up by not saving.

If you invest Rs 1 lakh in a fixed deposit that has a lock-in period of 5 years and pays 8.75% p.a. – you would have Rs 134,993 at the end of 5 years.  Had you not invested Rs 1 lakh – you would have paid Rs 30,900 on Day 0 and have Rs 69,100 to spend. Therefore, your effective after tax return is 14.33% p.a. Would you give up an investment opportunity like that?

The following table shows after tax returns for an investment of Rs1 lakh in a tax saving fixed deposit that pays 8.75%p.a. compounded quarterly.Notice that the higher your tax slab, the higher your after tax rate of return.

 

Tax rate (%) (p.a.) Amount received after 5 years(Rs) After tax return
30.90% 134,993 14.33%
20.60% 141,113 12.19%
10.30% 147,497 10.46% 

A system for pain-free wealth creation

Now suppose you had invested every single year for the last 5 years. You would be able to withdraw the first year’s investment (plus return) this year. Your maturing investments would, for the next 5 years, be able to replace whatever money you would be investing over the next 5 years. This cycle would continue forever and you would have effectively devised a system in which you would feel no cash-flow pain from making yearly investments.

 

What next?

There are dozens of tax saving investments in the market. Your financial advisor has probably tried to sell you quite a few of them. Your banker would have tried his/her best to do the same as well. You have a lot to choose from and are probably wondering which investment is best for you. We shall look into this in our next article.

 

Image Credit- Taxpremium.com

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