Are taxes eating into your returns?!

The investment world is vast and complicated, and most people often fail to see, or choose to overlook the intricacies involved. The decision on where to invest is often arrived at arbitrarily; for example because a relative/friend/ colleague recommended it.

 

But investing is much more than that. Investing involves not only looking at returns but also understanding impact of other variables like inflation or taxation on returns. In this article, let us look closely at the impact of taxation on returns.

 

Public Provident Fund (PPF) versus bank fixed deposits FD

On the face of it PPF and FDs may look starkly similar.Both are low-risk options and offer moderate and more or less similar returns. PPF has a 15 Year term; FDs can have varied terms.

 

Now coming to the tax aspects. As far as deductions are concerned, both are available for deduction under secion 80C. However, an FD with a lock in of 5 years qualifies.

 

Coming to the returns. Returns on FDs are taxable, but the return on PPF is tax-free. So, lets say, if both these options gave a return of 8 per cent. The post tax returns on PPF would still be 8 per cent but on an FD it would be 5.6 per cent (assuming you are in the 30 per cent tax bracket).

 

NSCs, KVPs and Govt. of India Bonds

National Savings Certificate (NSC) and Kisan Vikas Patra (KVP) provide a returns of 8 per cent. However, the interest is taxable and if you are in the highest tax bracket of 30 per cent, your post tax returns come to 5.6 per cent.

 

So other things being equal, you should be looking at investing in options which offer higher post-tax returns or preferably options which give tax-free returns. And as far as possible avoid investments in options where the returns could get taxed substantially. Let us look at some such options.

 

Equity MFs and stocks

In the long term, equities are relatively less risky and the systematic investing route can definitely help reduce the downside. Also, equity mutual funds or direct equities become tax efficient only in the long term. If you sell your equity mutual fund or share holdings after holding them for over 1 year, you would not be liable to pay any tax. If you sell them before 1 year, your gains would attract a short term capital gain tax of 15 per cent plus cess.

 

Insurance versus Pension Plan

Pension plans have always been a favorite among investors, the word 'pension' acting as a psychological soother. The premiums are paid during a certain tenure and at vesting (retirement age), the payouts start. These payouts will however be taxed at normal rates.

 

There is an alternate to this. All payouts from any type of insurance plans; guaranteed, bonus linked or Unit linked are tax–free. So why not choose a whole life insurance plan with an option of year-on-year withdrawals. Such payouts are tax-free.

 

Debt Funds Vs. Bank Deposits

Liquid funds are appropriate for very short term deposits.

Avenue	Bank deposit	Liquid plus
Amt Invt.	Rs 1 lakh	Rs 1 lakh
Tenure	90 days	90 days
Return (%) per annum #	5.25%	6%
Maturity amount	Rs 101270	Rs 101447
Returns	Rs 1270	Rs 1447
Taxability of returns	30.9%	-
Dividend distribution tax	-	14.16%
Tax applicable	Rs 392	Rs 205
Post tax yield	Rs 877	Rs 1242
Post tax returns (%) per annum	3.61%	5.13%

#Average returns for Liquid Plus funds for Jun 09
Tax rates are inclusive of 3% cess

 

If you are looking at a slightly longer tenure (more than 1 year), you could look at Fixed Maturity plans (FMPs) which would prove to be an interesting and efficient option. With the help of FMPs investors can get 'double indexation' benefit. This advantage can be availed by investing in an FMP just prior to the end of a financial year and withdrawing it after the end of the next financial year. Here's a quick look at how one could benefit by investing in FMPs as against FDs.

A 13 Month FMP, launched on March 2007, will mature in April 2008. It will pass through two financial years and thus has the benefit of double-cost indexation for the purpose of calculating post-tax yield.

Details	Bank fixed deposit	FMP - with indexation	FMP - without indexation
Investment Rs	10000	10000	10000
Indicative yield (annualised)	9.5%	9.5%	9.5%
Tenure (mths)	13	13	13
Maturity amount Rs	11033	11033	11033
Return/capital gain Rs	1033	1033	1033
Indexed cost Rs	NA	11214	NIL
Indexed long term capital gain Rs	NA	-181	NA
Tax rate	30.3%	20.6%	10.3%
Tax Rs	313	NA	106
Post tax gain Rs	720	1033	927
Post tax annualised return	6.63%	9.5%	8.52%

Cost Inflation Index FY06-07 - 519; FY08-09 – 582

As is evident above, the post tax returns of FMPs with double indexation can be significantly higher (over 50% higher returns), even while pre tax returns are similar.

Gold

Holding physical gold is risky, however, often it is the usual last resort for someone who needs money urgently. Sale of Gold jewelry within a period of 36 mths, is treated as short term capital gains and taxed at normal rates. Post 3 Yr horizon, one needs to accommodate indexation benefit and would end up paying roughly about 10%-20% of taxes. There is a definite need to give a second thought on undue acquisition of gold. Investing in Gold via Mining funds (mutual funds) / exchange traded funds would be far more tax-efficient.

Real Estate

Here again, it would depend on the holding period. If you sell off the asset before 36 months, you would have to pay taxes at normal rates. For any period exceeding 36 months, if the asset is a residential property, you have the option of claiming exemption if it is re-invested. However, not only is the asset illiquid, earning a decent return on income could take an average of 10 yrs – given that the market cycle is inherently longer.

The list of avenues is not exhaustive; we have touched on the key avenues. We leave you with the wishful thought to prioritize tax-efficient avenues for your investments.he list of savings / investment options presented here is not exhaustive; I have touched only on the more popular options and leave you with the thought that tax-efficiency is a key yardstick in evaluating investment options.

Summary

• Invest don't save
• Look at Post tax returns wherever relevant
• Wherever possible choose tax free/lower tax instruments
• Low risk – tax free combo would fit Traditional insurance options and PPF/VPF. Gold/Debt Mutual funds/Real Estate are relative less taxed than fixed deposits
• Medium/High Risk tax efficient avenues are Unit Linked Insurance Plans, Equity/Balanced Mutual Funds and direct equities
• Interest bearing assets are generally tax inefficient. Hence look at post tax return before investing.

Disclaimer: While we have made efforts to ensure the accuracy of our content (consisting of articles and information), neither this website nor the author shall be held responsible for any losses/ incidents suffered by people accessing, using or is supplied with the content.

Source: http://wealth.moneycontrol.com/columns/tax-planning/are-taxes-eating-into-your-returns-/13672/0