You would remember, going to a mall, shopping and saving. Once in a while it happenes that you shop prudently for say Rs. 5000, then at the counter, the clerk announces that if your total bill amounts to Rs. 6000, you will receive Rs. 200 cash back or some item worth Rs. 200 for free. You start adding items to your cart just to fill that gap of Rs. 1000. In this last minute shopping, you often purchase things which neither demonstrate your need nor your prudence. At last, you saved that 200 bucks, but for that to happen you ultimately had to spend Rs. 800 more than what you might have initially planned.
Unfortunately this behaviour doesn’t stop at saving while shopping only. It applies to tax saving also and involves spending of much higher amounts. The reason is that we don’t consider that tax planning is a part of financial planning. And that it requires same amount of attention that we give while doing financial planning, retirement or any kind of planning for that matter. But sadly, It’s largely a last minute excercise. A few thousand rupees are spent to save a few hundred rupees of tax. When the month of March approaches, people suddenly wake up to save tax and spend on whatever they can find. They will invest in Mutual funds, Tax Saver FDs, Charity, Insurances, PPF and any other tax saving product they can lay their hands on. That’s the reason why these products see highest selling in the month of March. All these only to fill the gap of that 1.5 Lakh limit of tax exemption.
• Last minute tax planning
Actually this is more dangerous than last minute shopping stated earlier. When you plan your taxes in such a manner, it is bound to affect your overall financial prospects.
○ Unnecessary Investments
This is the biggest drawback. Most people buy endowment insurance policies to save tax when in a hurry. Saving tax should be considered an additional benefit of insurance policies, not the ultimate purpose. As the year end approaches the chances are, you won’t get enough time for a due research regarding that insurance policy. And you could end up buying the the one which might not be suitable for you. After 3-4 years, you would have started exploring options for surrendering the policy. That too would be a losing preposition as you won’t be able to get full amount back on surrendering.
○ Locking of money
Tax saving financial products have longer time frame and locking periods. ELSS mutual funds have a 3 years while Tax saver FDs have a 5 years locking period. So, if not chosen wisely, your money could be stuck there for quite a while.
• What is the solution?
The solution is to start planning for your taxes from the beginning of the year, from the April itself. It will save your money from going into unnecessary lock-ins. And it isn’t that much complicated either. There are a few steps to follow and you should be good about your taxes. Let’s go…
○ Estimating total income
Estimating your yearly income will show you how your gross Income figure would look like. There is no need to find the perfect figure as only rough calculation will do. Take one Mr. Tax Planner (TP), whose monthly Income is Rs. 50k. He calculates his yearly income to be around Rs. 6L.
○ Estimating total tax
Now, calculate the total amount of tax you will have to pay without claiming exemptions. Our Mr. TP finds out that he falls under 20% tax bracket because his income exceedes Rs. 5L limit. So, as per current provision (FY- 2018-19) his tax liability will be as under.
Up to Rs. 5L (5% tax bracket)
->5 % of (2.5L*) = 12500
(*the other 2.5L is tax exempt for all people below 60 years, for people above 60 years it’s 3L and 5L for people above 80 years.)
Up to Rs. 10L (20% tax bracket)
->20% of (remaining 1L) = 20000
Therefore his total tax liability, in case he doesn’t want to save any tax, will be
->12500 + 20000 =32500.
So, he will have to pay Rs. 32500 if he decides not to save any tax.
○ Current investments/payments
Find out where you are investing currently. You may already have premiums of life insurance policies, ELSS mutual funds, Tax saver FDs, PPF, EPF(for salaried class), NPS etc. Find out how much all those investments amount to. Our Mr. TP recalls that he has one term insurance, a floater health insurance, a SIP in an ELSS fund, investment in PPF and installments of a home loan. Yearly payments for them are as under.
Rs. 15K – TI
Rs. 20K – HI
Rs. 36K – SIP
Rs. 100K – PPF
Rs. 180K – HL installments (EMI of Rs. 15K)
○ Calculating exemptions
His investments in TI, SIP and PPF comes under section 80C, so even if he is paying total of Rs. 151K, he will be able to claim only Rs. 150K as exemption. But what about health insurance and home loan repayments? Investment in HI up to Rs. 25K is exempt as per another section 80D, which is in addition to the limit of section 80C. As for HL repayments, the interest certificate he received from the bank shows that out of Rs. 180K that he would pay, Rs. 120K would go towards interest. This entire Rs. 120K will be available for exemption in addition to limits mentioned above. HL interest is exempt upto Rs. 2L.
There are various other provisions like HRA for salaried persons, special exemption for differently abled people, child education fees, extra Rs. 50K investment in NPS, etc. which can reduce the overall tax liability.
○ Finalising tax payable
Now that we have listed out investments for Mr. TP, we can finalise his tax liability as under.
Total income Rs. 6L
Less 1 – HL interest (Rs. 120K)
2- Health Insurance (Rs. 20K)
3 – Total of sec. 80C ( Rs. 150K)
= 3.1L (Net taxable income)
Less standard deduction (Rs. 250K)
Since net taxable income falls under Rs. 5L, tax will be 5% of 60000, that is Rs. 3000
○ Keeping an eye out
So, Mr. TP finally calculated how much tax he will have to pay. Remember, we have done this excercise at the start of the year. So, it may be possible that the actual tax payable may differ at the end of the year. So, it is advisable to revise your calculations based on changes in income. This happens especially when one receives capital gain, bonus, increment or arrears etc. Though, once the tax planning has been done in advance, watching over it for further changes will be fairly easy.
Thus, by carrying out early tax planning, Mr. TP effectively managed to guide his investments in such a way that he was able to reduce tax burden too. When you plan your taxes in advance you will have enough time to research and compare various products and their suitability, and reduce the risk of unnecessary investments. Even if an emergency tax situation arises at the end of thr year, never buy endowment insurance policies to just save tax. They are long term products. And long term products should not be bought with short term decisions. In such a case, look for the product with the shortest term, ELSS mutual funds. While insurance, PPF and Tax saver FDs have locking period of more than or equal to 5 years, ELSS funds have a locking period of just 3 years and may earn you better returns too. Also, you will get hold of your money back early.
Tax planning is not to be done separately of your investments. When you decide to invest somewhere according to your goals, find out what kind of tax benefits you will get. Almost all investment categories provide tax benefits in some form or the other. It may take some research to find such a product, but once you have chosen, it will serve both of your objectives, i.e value investing and tax planning.
So, that’s it for this post. Will be back soon…