Tax savings — Higher returns, optimal portfolio

Tax savings — Higher returns, optimal portfolio

Suresh Krishnamurthy

IN THE end, the Budget proposals must have come as a pleasant surprise to salaried taxpayers and the self-employed, especially the latter. The expected overhaul of personal tax laws has not increased the tax incidence, and taxpayers have ended up with a pretty fair deal. The proposals will result in lower taxes, whether you save or not. If you save, you will gain more.

The crucial change, which can galvanise personal investing, is the introduction of a consolidated limit of Rs 1 lakh for all tax-saving investments without any ceiling on individual options, and for certain expenditure items.

Portfolio allocation, however, can now be optimised, with a certain proportion reserved for equity . There is no need to hold a portfolio separately for tax savings and another for other investments. This could increase returns significantly.

The present dispensation should, however, only be viewed as a window of opportunity that will close any time.

The changes represent the first steps in the transition to a state in which investments that earn tax savings will be taxed at the time of redemption. As things stand, investments which earn tax savings are not taxed at the time of redemption. Investors, as such, need to be on guard and should not fritter away the advantage by investing in low-return options. They particularly need to guard against aggressive marketing of sub-optimal insurance plans.

Limited options

Until now, investors suffered from a severe dearth of options. Consider this.

The just-concluded public offer of bonds by IDBI attracted subscriptions of Rs 2,100 crore when the offer size was only Rs 800 crore; the coupon on offer being less than 6 per cent. This is because you had no option if you wanted tax savings from infrastructure bonds.

In the year ahead, however, you need not restrict yourself to these bonds. You could invest in pension plans of mutual funds and insurance companies or in small savings schemes. These options offer significantly higher returns than infrastructure bonds.

Even the National Savings Certificate, which offers an annual return of 10.4 per cent for investments made after the new tax laws come into effect, offers a better deal than infrastructure bonds. The yield-to-maturity of infrastructure bonds, such as those issued by IDBI, even under the existing laws, was lower at about 9.4 per cent. If the coupon rate remains unchanged, the yield will plunge to 8.2 per cent under the new laws.

In the proposed tax structure, the NSC is a sub-optimal option as the interest accrued each year would be subject to tax. Investment options such as provident fund that provide tax-free interest will fetch higher returns. Employee provident fund, for instance, can fetch returns of about 12 per cent.

Expenditure: First claim

Before making investments to get the benefit of tax savings, however, you may want to use the specific expenditure that is allowed as part of the limit of Rs 1 lakh. This will help you get tax savings when your annual investments are less than Rs 1 lakh. The list of such expenses includes:

Stamp duty and registration fees paid at the time of purchase of house property, Repayment of principal on existing and new home loan, Tuition fees paid in respect of child (It is not restricted to two children. If you invest Rs 1 lakh or more each year then it does not matter. You will get the entire benefit even without having to show the expenditure as part of the limit. If such individuals were in the 20 per cent tax bracket, the tax benefit would reduce the cost of a 9.5 per cent fixed rate home loan to about 6 per cent. If they are in the 30 per cent tax bracket then the effective interest rate would come down to about 4 per cent. If the fixed rate is 9 per cent, then the effective interest rate would come down to 3.5 per cent for an individual in the 30 per cent tax bracket. Equity or not If employee provident funds can fetch me after-tax returns of 12 per cent per annum, do I need to invest in equity at all? This is a legitimate question, especially for investors with either a lot of money in their hands or none at all. Equity is appropriate for these investors, too. Consider the risks involved in EPF or PPF. The rate of interest could fluctuate and could trend lower over the next few years. If liquidity in the system keeps rising and the economy is in good shape, then the interest rates offered by these schemes could dip. Importantly, EPF managers themselves are looking to invest in equity to sustain the returns at higher levels. In addition, it would be appropriate to compare the returns of equity and debt without tax benefits. For instance, EPF offers you 9.5 per cent and PPF 8 per cent. But with the economy poised to grow steadily over the next few decades, return expectations of about 12 per cent from equity do not seem unjustified. Optimal portfolio First, for most investors, there is no need to consider a portfolio for tax savings and another for non-tax saving. This is true if they have a long-term perspective and the schemes they invest in are largely restricted to provident funds, pension funds offered by mutual funds and insurance companies. This is also the case for most investors who lack the expertise to invest in stocks directly. Incidentally, there are only a couple of pension funds offered by mutual funds now. The array of available options is, however, likely to increase significantly over the next year. In this backdrop, allocation of 50 per cent to balanced fund options in pension plans of mutual funds and insurance companies appears optimal. It would peg an investor's exposure to the equity market at 20-25 per cent. This would enhance returns and also appeal to the conservative mindset of most investors. The rest can be invested in provident funds and pension plans that invest their entire assets in debt investments. If they have a shorter-term perspective of less than 10 years, then they can consider investing 40 per cent in mutual funds and split the rest between small savings and provident funds. While investing in the pension plans of insurance companies, taxpayers should ensure that their purchase of term insurance is not more than what they need. If you buy more term insurance than what appears justified under the circumstances, it will only act as a drag on returns. If you want to invest more than Rs 1 lakh and prefer debt options, you should seriously consider debt mutual funds. This is because the Budget has eroded the competitiveness of the POMIS significantly. Its yield-to-maturity under the new dispensation — with interest not deductible under Section 80-L — comes down to 7.5 per cent, as against 9.3 per cent earlier. With yields on corporate debt inching higher to above 7 per cent, tax-efficient and liquid debt mutual funds can offer competitive returns.