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The long-term tax saving guide

Pick up instruments that help save tax as well as give direction to your portfolio and fit into your overall financial plan. Deepti Bhaskaran, Lisa Pallavi Barbora and Bindisha Sarang report.

india Updated: Feb 03, 2012 22:14 IST

Saving tax just for the sake of it may not bode well for your overall portfolio allocation. Pick up from a list of products that are meant for the long term. Instruments such as Employees' Provident Fund, Public Provident Fund and National Pension System are products you must have in your retirement portfolio; Life and health insurance products are a must have: Infrastructure bonds provide that extra edge of savings and you can make them part of debt portfolio.

EPF: A must have for salaried individuals
Your first choice under section 80C. For salaried individuals, Employees' Provident Fund (EPF) is a very good long-term investment vehicle, especially if you want to invest for your retirement. Every month, you and your employer contribute 12% of your basic salary plus dearness allowance in the EPF account. While it is mandatory for employees having a basic salary of Rs 6,500 per month, for those earning above that limit, the contribution is voluntary. The 12% that you contribute qualifies for a tax deduction under 80C up to Rs 1 lakh. If you encash your EPF after five years, the proceeds are tax-free.

From what your employer contributes, 8.3% of the contribution goes into the Employees' Pension Scheme, or EPS, which offers you pension for life at the age of 58 years. The remaining corpus then earns a rate, which is declared by Employees' Provident Fund Organisation (EPFO) for each fiscal.

Even as EPF has been consistently declaring a rate of 8.5%, for FY11 EPFO declared a rate of 9.5% on the back of a surplus. However, for this fiscal EPFO is yet to declare a rate.

Even at 8.5%, EPF can work a neat sum of retirement nest egg for you.

Assuming you contribute 12% of your basic plus dearness allowance every month (assuming you are 25 and earn Rs 20,000 per month) to your EPF account, by the time you retire, you would have a kitty of around Rs 1.4 crore, assuming the interest rate remains at 8.5% and you get a modest hike of 5% a year in your salary.

PPF: Allows you to invest, get more
From 2011-12, the returns on your Public Provident Fund (PPF) will vary every year. Last year, the government made the National Small Savings Fund market-linked. The returns on PPF will be pegged to the average government securities (G-secs) yield of similar maturity of the preceding year and will have a positive spread of 25 basis points (100 basis points is 1 percentage point). So if the average G-sec yield is 8%, the rate for PPF will be 8.3%. The rate will be declared before April 1 each year for the next fiscal. For 2011-12, the rate is 8.6%.

PPF is a risk-free and tax-free product that gives positive returns after accounting for inflation. For about six years, PPF has given a return of 8%. Assuming that in the long term inflation is around 6%, the real rate of return or inflation-adjusted return from PPF is 2%. What also helps is the tax treatment of PPF. The contributions you make to PPF - from this year you can invest up to Rs 1 lakh as opposed to Rs 70,000 per annum earlier - qualifies for a tax deduction of Rs 1 lakh under section 80C. On maturity, the proceeds would be tax-free. Even under the proposed direct taxes code, PPF will continue to enjoy the same tax advantage.

Given the favourable tax treatment, PPF remains an attractive proposition for long-term savings.

Infra bonds: additional advantage
In the last six months, there have been many public issues of tax-saving infrastructure bonds that hit the market. Under these, you get a tax deduction on an investment up to Rs 20,000 under section 80CCF. Thanks to the high interest rate environment, the coupon rate is also attractive. The five such issues that are currently open are offering 8.7-9.2% per annum.

They usually offer two interest payment options: annual and cumulative. In the annual option, the interest is paid every year; in the second option, all the interest is paid together at the end of the tenor or at withdrawal.

For the cumulative option, the interest is compounded so it works out better.

While most bonds come with a 10- or 15-year maturity, investors have an option to tender bonds in a buy-back at an earlier date. This is like an early exit option. Typically, buy-backs are scheduled at the end of five or seven years.

Before buying the bonds, look at their credit rating. While they provide no guarantee, they are an indication of the issuer's ability to repay debts and also fulfil financial obligations such as interest payment. AAA or equivalent rating shows best quality and AA or equivalent rating indicates very low credit risk.

Life insurance: Stick to basics
The premium you pay towards one or multiple life insurance policies for yourself, your spouse or your children are eligible for section 80C deduction. Though various types of life insurance policies, such as endowment assurance policy, money-back policy and unit-linked insurance plans are eligible for tax deduction, we advise you stick to term plan.

Term plans provide a large cover for a relatively lower premium compared with other policies. Here you pay premiums every year and the sum assured gets paid to your nominee if you die mid-term; if you survive the term, you get nothing back. Typically, term plans are available till 65 years of age and you can choose a term between five and 35 years.

Most term plans are level premium paying policies - you pay the same premium for the entire term for the same sum assured. But there are other variants too. An increasing term policy will increase your sum assured periodically, while a decreasing term policy will reduce it. Decreasing term covers work well for people who take home loans. Some term plans offer returns and are called return of premium plans - they return the premiums on maturity. There are convertible term plans, too, which can be converted into another type of life insurance; for instance, whole life.

So, ignore the noise on return and stick to a basic term plan.

Health cover: beats soaring costs
Premiums paid for a health insurance policy provide a deduction of Rs 15,000 under section 80D; for senior citizens, the benefit is Rs 20,000. You can claim an additional benefit of Rs 15,000 if you are paying premiums on behalf of your parents. If your parents are senior citizens then you can claim an additional Rs 20,000.

The most basic health plan is an indemnity policy that covers hospitalisation expenses. Typically, pre-existing diseases are not covered up to four years initially. However, some plans may cover you after two-three years. Some policies are restrictive as they may have sub-limits under each head of expense; most senior citizens get policies with sub-limits.

"For a normal individual with a normal family, without any major disease history, around R5 lakh of medical cover is optimal," said Suresh Sadagopan, certified financial planner.

When buying a policy, remember that the cheapest may not be the best. "While most medical policies are more or less similar, you should look at extended benefits," said Sadagopan.

A good policy is one where paying the premium amount is the only expense and the rest is taken care of.

NSC: 1 interest rate till maturity
Now National Savings Certificates (NSCs) are available for a tenor of 10 years as well. Just like Public Provident Fund (PPF), the rate on NSCs will be pegged to government securities' (G-secs) yields. Additionally, it will have a spread of 50 basis points. So if the G-sec yield is 8%, 10-year NSC will yield 8.50%. For 2011-12, the rate for 10-year NSCs is 8.7%.

Unlike PPF, where the rate of interest will vary every year, in NSC you will get locked into the prevailing rate until maturity. So if you bought a 10-year NSC this year, the rate of interest of 8.7% will be applicable for the entire tenor. In isolation, 8.7% looks good, but compare it with PPF and broaden the analysis to include the tax treatment.

The contributions you make to NSC qualify for 80C deduction up to R1 lakh; subsequently even the interest that accrues every year and gets reinvested qualifies for the 80C deduction. However, on maturity the interest income is taxed at your marginal rate. So if you are in the highest tax bracket of 30.9%, the effective rate of return on your 10-year NSC that yields 8.7% will be 6.0%. Compare this with PPF that gives a tax free-risk free rate of 8.6% or even an FD. At present, FDs offer a rate up to 10% and five-year FDs also qualify for deduction under 80C. Assuming a tax bracket of 30.9%, the effective yield on an FD will come down to 6.91%.

NPS: Invest in small portions
The tier-1 structure of the National Pension System (NPS) is a good investment vehicle if you are looking to build a retirement corpus. NPS is a pure defined contribution product, which has a lock-in till 60 years of age. You can begin with a minimum annual contribution of R6,000 in the funds and fund manager of your choice. Your contribution qualifies for a tax deduction up to R1 lakh. There is no limit to the contribution you make in NPS, but only 10% of your income is applicable for tax deduction under section 80CCD. However, the deduction is available subject to the R1 lakh limit under section 80C.

At present, there are three funds and two investment strategies to choose from. You can allocate up to 50% of your investment in equity fund (E), fixed-income instruments other than government securities fund (C) and government securities fund (G). You can either make the allocation yourself (active choice) or go for auto choice, which reduces the equity exposure as you grow older.

On maturity, you can withdraw up to 60% as lump sum, the remaining 40% goes into buying an annuity, a pension product that pays you periodic income.

The 60% lump sum you take is taxable as of now; however, the proposed direct taxes code (DTC) is likely to give it exempt-exempt-exempt status, which will make the returns tax-free.

If you belong to the unorganised sector or are self-employed without Employees' Provident Fund benefit, you must consider NPS.

"NPS is currently undergoing a lot of changes," said Sadagopan. "What the tax treatment will be under DTC and by how much will the fund management charge increase remains to be seen. For now, invest only a small portion in NPS."