Balancing Between Tax Saving And Growing Wealth
The government encourages the public to save by incentivizing them with tax benefits. It is ideal for citizens to have savings and look after themselves because it puts less financial strain on the government and well, it is also good for the economy.
However, tax saving investments are designed to be as popular as possible (or as “good for everyone” as possible). For the most part, these investments will usually be low risk and therefore can only offer modest returns, because risk typically corresponds to potential returns.
When you make a tax saving investment, you save on tax you would have otherwise had to pay, plus, you typically earn some interest (though how far this is guaranteed and what amount you receive depends on the type of investment). The sum of tax saved plus additional interest is quite a good deal… but there’s a bigger picture to consider.
Key considerations in achieving a balance between tax saving and growing wealth
- You only save tax for Rs 150,000 of your income under section 80c of the Income Tax Act that pertains to tax saving investments. You might get some additional Rs 25,000 to Rs 100,000 deductions for medical insurance premiums paid (but those do not count as savings). All types of tax saving investments considered, you only get a deduction on Rs 150,000 invested. Anything invested over and above does not buy you additional tax deductions.
- Because low risk corresponds to low returns, investors who have the bandwidth to sustain even moderate risk are forgoing potentially higher returns.
- The lock-in period for tax-saving investments is typically 5 years. That’s a long time to be kept away from your hard-earned capital. Liquidity should always be a consideration when you invest.
- As one might have observed in news articles regarding certain banks, even fixed deposits today sometimes do not offer the amount of safety as they used to. The investors of banks in the headlines for the wrong reasons are very likely to get back their money, but it may be some time before they can actually get their hands on their capital again.
- If you are investing towards financial goals such as retirement, financing the education and future of children, buying a home and so on, you might need to reach for a higher rate of returns in order to beat inflation by a sufficient margin and meet the cost of living in the future.
Some options that allow investors to pursue both tax saving and high returns
You probably already know of the popular low risk: low to modest returns options such as fixed deposits, public provident fund, national pension scheme and so on. Let’s look at three options that investors can consider when they have a moderate to high risk appetite.
But let us understand risk appetite first:
Investments range from very low risk to very high risk. Risk appetite pertains to the amount of financial risk you are willing to take in return for certain potential earnings because risk corresponds to potential returns. Risk may pertain to actual capital loss or might pertain to fluctuating returns. It is up to the investor to choose where on this spectrum he is most comfortable.
Ideally, investors should only accept risk on capital that is over and above the money they need to sustain their current lifestyle, and if they have a regular income that can allow them to replenish any capital lost.
Now we are ready to look at investments that let you choose your risk:reward ratio.
# ELSS mutual funds
Equity Linked Saving Scheme is a tax-saving investment option under section 80c of the Income Tax Act. However, although it is low risk, being market-linked, ELSS mutual funds are capable of delivering fairly high returns.
They come with several pros:
- The lock-in period is 3 years as compared to 5 years for other tax saving investments
- They have a lower proportion of equity (stocks) investments as compared to debt (bond) investments which corresponds to lower risk because bonds are typically lower risk than stocks
The cons are:
- There is risk in anything stock market related
- 3 years is still a substantial lock-in, (but that said, if you need to save tax it’s the shortest commitment on offer).
# Long term equity investments
If you have already completed your tax saving quantum of investment and are looking for investments where you pay low tax on your returns, while also aiming for higher returns, you should consider carefully selected stocks.
- Choose companies based on their financial strength and earnings potential (and not hype) to lower your risk
- Ensure you buy in at the right time (and sell at the right time).
- Set a stop loss that will sell your shares if the stock price starts to go too low.
Risk plateaus out in the long term – you will not be playing the high risk- high stakes game that day traders play. Any earnings (up to Rs 100,000) are not taxed, provided the capital was invested for more than 12 months, rendering the gains as long term capital gains.
# Tax saving bonds
When you purchase a bond, you are essentially lending capital to the bond issuer and you receive a predetermined sum of interest from them. Some government bonds and municipal bonds (called muni bonds) might offer tax incentives and tax deductions.
Bonds are seen as safer than stocks because the bond represents a commitment of repayment. Moreover government bonds usually come with a low risk of defaulting.
Bonds can also be sold on the open market should the investor suddenly need the capital – this makes them fairly liquid investments.
Conclusion: Go from being just a diligent saver to being a smart and savvy investor, who pursues wealth growth by intelligent choices. Your lifestyle will thank you years down the line. It is easy to learn about investing and to invest online thanks to online investment platforms. You can even get expert advice to help evaluate your risk appetite and choose appropriate investment categories.
A parting note: do not forget about risk in your pursuit of wealth. Always get a 360 degree understanding of any investment.