It’s the time of the year when our C.A. starts chasing us for “tax planning”. Where have you done the investments and what deductions can you get? This should have ideally been raised in December, but then that is rarely the case. Some of the short term fixes available to investors include (i) PPF – where the investment is eligible for savings under section 80C; (ii) NPS – eligible for tax deduction under 80CCD; (iii) ELSS – tax saving mutual funds; and (iv) Insurance – but remember this should be viewed primarily as a risk cover and the investment attractiveness should be secondary.
Before you jump into short term (and hopefully not sub optimal) investments just for “tax planning”, there are a few other things you can do to maximise post tax returns in the long term.
Indexation: This is a very powerful tool that all investors should know about. Indexation allows you to adjust (upwards) the purchase price of a product. The idea is that the value of the asset should be a true “inflation adjusted asset value”.
Capital Gains: When you sell a product, profit is sale price less cost price. When the profit is sale price less the “indexed” cost price, the profit is termed as “Capital Gains”. Capital Gains should therefore be lower than profit as the indexed cost would be higher than normal cost.
Tax advantage of Debt funds over FDs
The tax authorities allow us to use indexation and capital gains for our long term capital assets (i.e. generally held for more than 3 years), a concept more widely known as long term capital gains. We use it for real estate exits, but this can also be used for investments in other financial assets like debt mutual funds, bonds, gold, etc. Returns on Fixed Deposits do not benefit from indexation and this creates an interesting opportunity for debt mutual funds. The table below should put post tax returns in perspective.
While Debt mutual funds carry risk, they can provide investors attractive risk adjusted returns. If entry and exit is planned properly, the post tax returns can be quite attractive.
Dividend or Growth?
One more thing to note – Investment options come in dividend or growth plans. When dividend is selected, the surplus is paid out and taxed as dividend distribution tax (c. 29%). Once paid out, the value of the investment (NAV) will fall to the extent of the payout. If the redemption value has fallen, the difference between the initial investment and holding value will perhaps not justify a longer holding period / taking advantage of Long term capital gains. So to make best use, value needs to be accumulated and added to the NAV i.e. selecting a growth plan.
To summarise, in addition to short term quick fixes, long term planning can also effectively deliver superior tax adjusted returns. If you are doing the debt fund, better before 31st March than after 1st April.