Categories: General

Personal Finance Rule 5 – Tax Savings is not mandatory

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This short post warns against excessive focus on investing to simply save taxes. This results in sub-optimal results. This is a companion post to the India version of Harold Pollack’s Index Card – Pollack’s Index Card: All the financial advice that you ever need – India version

What are Tax Savings?

While the term tax savings is loosely used to refer to ways to reduce taxes, there are three formal terms used by the Income Tax Department.

Tax Exemptions – These are defined under various sections and specify income types where taxes need not be paid – e.g agriculture income, dividend income below 10 lacs, NSC interest, etc.
Tax Deductions – These too are defined under various sections. They include items that can be deducted from the taxable income. These include both expenses like donations, school fees, etc. and investments like EPF, PPF, etc.
Tax Rebates – These are deductions, or ‘discounts’ in the actual tax to be paid. Till FY2018-19, a tax rebate upto 2,500 was provided for people with taxable income < 3 lacs. The 2019 budget made this a rebate of 12,500 for people with taxable income upto 5 lacs

The terms tax savings, tax deductions, etc. are loosely applied to the first two categories.

Handling Tax Exemptions

This is a simple thing to understand. If you received an income that is exempt from tax, you obviously want to declare it correctly and not pay any tax on it. Almost all income from agriculture is exempt. For most tax payers, the following are the most common exemptions that can be claimed.

Proceeds from life insurance (with some restrictions)
Dividend income from shares upto 10 lac
Dividend income from mutual funds (Do note that mutual fund dividends are sub-optimal in India)
Interest from savings accounts upto 10,000
For senior citizens, interest from fixed deposits upto 50,000
Interest for tax saving bonds
Many allowances for salary earners, with specific limits
and so on

In almost all cases, these exemptions are automatically handled. Allowances, etc. are deducted from the reported salary income. Other income like dividend income, savings account interest, etc. can be filled in the right part of the ITR forms and would be adjusted automatically.

Tax Savings on expenses

More formally these are deductions that can be applied to taxable income. Due to a variety of reasons, some expenses are deemed as ‘beneficial’. People are then encouraged to incur them by way of tax deductions. These deductions are covered under multiple sections – 80C to 80U, 24, etc. Almost all of them have their own limits.

Principal repayment for primary home – 80C
Stamp duty, etc for house – 80C
Tuition fees for school going children – 80C
Life insurance premium – 80C
Health insurance premium – 80D
Interest on education loan (no limit) – 80E
Donation to charitable causes, political parties, scientific research – 80GGX
and so on

Obviously you should not incur an expense just because it has a tax deduction. However if you can’t avoid those expenses, then definitely declare them appropriately and claim deductions.

Please note that life insurance premium has been listed here as an expense. And it should be only an expense. It is quite injurious to mix insurance and investment.

The funny business of Sec 80C and friends

Most of the expenses listed above have their own sections, but the first four are covered under Section 80C. This section, with its friends 80CCC and 80CCD, interestingly also covers many possible investments. These three also have a combined, reasonably large limit of 1.5 lac. Almost all poor tax savings decisions happen under this section. People are led to believe that they should make full use of the 1.5 lac limit. They end up making investments in products that are not suitable for their situation.

The investments under this section are below.

Public Provident Fund
Employee contribution to EPF (and VPF)
Self contribution to NPS Tier 1 account
National Savings Certificate
Tax Saving Fixed Deposit
Senior Citizen Saving Scheme
Sukanya Samridhi Yojana
Pension plans from mutual funds and insurance companies
Tax saving mutual funds (ELSS)
and so on

Typical mistakes made with 80C

Many people, in particular, young earners, seek to utilize all of the 80C limit. This is not a bad thing as such. (In fact, the 2019 budget would motivate people with incomes in the range of 6 to 9 lacs to max out 80C.) However most people approach this in the wrong way. They buy a product/make an investment just to use the limit, without looking at the long term impact. The worst manifestation of this to buy investment linked insurance policies.

The most optimal way to use Section 80C would be as below.

Start the tax savings plan in April of every financial year (Don’t wait for end of the year, or when your employer asks for investment proofs)
Consider fully all the ‘expenses’ covered under 80C
Include mandated contributions like EPF, NPS
Include PPF contribution per financial plan
For equity part of portfolio, if any, use ELSS mutual funds
If long term fixed deposits are part of the financial plan, use Tax Saving Fixed Deposit

If these don’t use the 1.5 lac limit, it may be helpful to stop. The simple fact is that for most people, Items 2-3 would continue to grow and soon reach quite close to the 1.5 lac limit. e.g Salary increases would increase EPF/NPS contributions, People may buy homes and pay back principal, They can have children and increase life cover, Children would go to school, etc. The gap, if any, can always be filled by PPF contributions. (PPF is something every Indian should use as much as possible.)

Conclusion

To optimize tax savings, you can do the following: Use all tax exemptions available for income, Include all deductible expenses, and then include investments aligned with your financial plan.