Tax Planning for 2009

The Public Provident Fund (PPF) offers tax exemption on the invested amount, there`s no tax on the interest earned, and even withdrawals are tax-free. Most importantly, the PPF is a government-sponsored scheme and is, therefore, completely safe.

The various tax-saving avenues under Section 80C can be used by individuals to suit their financial needs. We analyse the available options.

This is everybody's favourite tax-saving option and it's no surprise. The Public Provident Fund (PPF) offers tax exemption on the invested amount, there's no tax on the interest earned, and even withdrawals are tax-free. Most importantly, the PPF is a government-sponsored scheme and is, therefore, completely safe.

The other huge attraction of the PPF is that you can take a loan from the account in the third year or make partial withdrawals after the sixth year. The loan can be up to 25% of the balance in the account and has to be repaid in not more than 36 EMIs. Of course, if the thought of paying a 12% interest on your own money is galling, you can opt for a partial withdrawal after the seventh year.

PUBLIC PROVIDENT FUND (PPF)

The old faithful | Maximum limit: Rs 70,000
Not locked up for 15 years

When possible Limit
Loans In 3rd financial year 25% of balance in account at end of first year
Partial withdrawals In 7th financial year 50% of balance in account 3 years previously or in previous year
March 31 is the cut-off date for calculating the balance for the year.

You can withdraw up to 50% of the balance in the account that was present three years previously or in the previous year, whichever is lower. The end of the financial year (March 31) is taken as the cut-off date for calculating the balance. So, if a PPF account was opened in 2002-3, then the first withdrawal can be made during 2008-9 and the amount will be limited to 50% of the balance on 31 March 2005 or 31 March 2008, whichever is lower. This facility is particularly useful if you're facing a cash crunch. Simply withdraw from the PPF account and reinvest.

However, don't go overboard while investing in PPF. In the long run, its returns will never be able to match the phenomenal potential of an equity-based option. If you can stomach a little risk, don't put too much in this low-return avenue.

Advantages

1. Completely safe
2. 8% assured returns
3. Income is tax-free
4. Contribution is flexible

Drawbacks

1. Returns lower than prevailing FD rates
2. Withdrawals limited
3. Locks up capital for the long term

Best Suited For

Risk-averse investors, self-employed professionals and those not covered by the EPF.

FIVE-YEAR FIXED DEPOSITS

Returns are high, but taxable | Maximum limit: Rs 1 lakh
Best five-year FD rates
Bank Interest Rate (%) Post-Tax Yield (%)
ICICI 9.0 7.85
Oriental Bank of Comm 9.0 7.85
Indian Overseas Bank 9.0 7.85
Bank of Baroda 8.5 7.32
Axis Bank 8.5 7.32
Post-tax yield for an investor in the highest tax bracket

Never judge a book by its cover, they say. Or the suitability of an investment option by its advertisement. Banks are crying themselves hoarse with offers of attractive rates of interest on fixed deposits.

At 9%, the returns offered are higher than what your PPF contribution earns. But then, as another cliche goes, if it's too good to be true, it probably is. In this case, the income earned on the fixed deposit is taxable; it is added to your income for the year and is taxed at the applicable rate. So, if your income is in the 30% tax bracket, the post-tax return from the fixed deposit is actually lower than what the PPF offers.

There's also the vital issue of safety. Banks are perceived as safe havens. But in 2008, we saw that even these safe havens can fall. So, steer clear of little-known private and cooperative banks that offer great rates. If they fold up, your money is gone. Stick to public sector banks and well capitalised private entities. They might offer rates that are a tad lower, but at least your capital will be safer.

Fixed deposits are suitable for retired taxpayers and those with an income of less than Rs 3 lakh a year. At that income level, the tax rate is only 10% (plus 3% cess), which still leaves a lot on the table for the investor. Retirees have another option in the Senior Citizen's Savings Scheme.

Advantages

1. Attractive returns of 9%
2. Widely available
3. Shortest lock-in (5 years) among debt options

Drawbacks

1. Income is taxable
2. Safety not assured
3. May not match returns from equity over 5 years

Best Suited For

Senior citizens who don't want to go in for long-term options; those in low tax bracket.

EQUITY-LINKED SAVING SCHEMES (ELSS)

Rewarding for risk-takers | Maximum limit: Rs 1 lakh
The five best schemes
Scheme NAV (Rs) Returns in 6 Months Returns in 1 Year Returns in 3 Years
Sundaram Paribas Taxsaver 23.57 -22.04 -49.05 4.56
Canara Robeco Tax Saver 11.13 -19.11 -48.17 4.42
Principal Personal Taxsaver 46.43 -38.94 -62.53 1.79
Sahara Tax Gain Fund 17.00 -20.75 -50.01 1.37
Franklin India Taxshield 96.00 -25.21 -50.50 -0.46
Category Average
-31.26 -56.86 -4.73
Returns as on December 26, 2008. Three-year returns are annualised.

Equity-linked saving schemes were seen as the best things since sliced bread till the markets crashed. Today, the same investors who went to town recommending ELSS to their friends and family are sitting tight; some of them have stopped their SIPs. After all, who wants market-linked returns when the market has more than halved in value in 12 months?

But this is exactly why you should give ELSS a chance. "To make money in equities, one has to jump in when there is an overwhelming fear because that's when a lot of assets get undervalued due to irrational pessimism," says Ajay Bodke, senior fund manager, equities, IDFC Mutual Fund.

Experts are unanimous that the stock prices would revive after some time. "The markets are likely to bottom out in a couple of months. After this, there could be a phase of very low activity and a revival may happen some time during October-December. Therefore, the best time for investing is between now and April," says Jayesh Shroff, fund manager, equity, SBI Mutual Fund. If you intend to invest in equities in 2009 and still have some tax planning to do, ELSS funds should be your first choice.

Yes, of course an ELSS carries the same risks as an equity fund. But the risk is not high if you are a long-term investor who doesn't get spooked by notional losses. "Fear and greed linked to short-term market movements eventually lead to mistakes. Last year's trend in equity markets should not come in the way of regular, steady investing," says Anup Maheshwari, executive vice-president and head of equities & amp; corporate strategy, DSP BlackRock Investment Managers.

Analysts also believe that the markets will continue to be volatile in the short to medium term. The best way to beat volatility is by taking the SIP route which averages out your cost of purchase.

Advantages

1. Stock markets at a low
2. All income is tax-free
3. Short lock-in period of three years

Drawbacks

1. Returns and risk are market-linked
2. Investor cannot exit even if markets crash

Best Suited For

Investors with a longterm horizon who are not averse to taking calculated risks.

UNIT-LINKED INSURANCE PLANS (ULIPS)

Not for short-term investors | Maximum limit: Rs 1 lakh
Tax-free Gains

Short-Term Gains Long-Term Gains
Ulips Nil Nil
Equity funds 15% Nil
Debt funds Marginal rate 10%

What is a Ulip? To the short-term investor, it is a high-cost mutual fund that charges an entry load of 30-40%. To the long-term investor, it is a useful asset allocation tool. To the savvy investor, it is a great way to time the market by switching in and out of equities without paying any short-term capital gains tax. And to taxpayers, it is an investment plan that gives tax benefits, insurance cover and the possibility of great returns.

So why are so many Ulip investors planning to change them to paid-up policies? Thanks to the market crash of 2008, the value of the corpus invested in equities has almost halved. But, says Anuj Agarwal, CFO of SBI Life Insurance: "Over an investing horizon of 20 years, the crash of 2008 will be a small blip."

Clearly, Ulips are not for short-term investors. Invest only if you plan to continue with the policy for at least 10-12 years. Before that, the Ulip may not be able to recover the high charges that are levied in the initial years. While mutual funds charge an entry load of 2-2.5% (and even that is waived for direct investors), Ulips charge up to 40% in the first year, 20-25% in the second year and 5-10% in the third year. "Ulips are ideal for individuals who are willing to take a higher risk to seek a higher return," says Manik Nangia, corporate vice-president and head of product management, Max New York Life Insurance.
Tips
Use the switching facility in the Ulip pro-actively to rebalance your portfolio.
If you don't want to pay high initial charges, use top-up facility to increase investment.
Invest only if you can continue for 10-12 years. Before that, a Ulip may not be viable.

Ulips score over ELSS funds because they allow switching between the equity and debt options. Investors can change their asset allocation depending on the market movement. And they don't pay any capital gains tax on this. Some plans, such as the Horizon Automatic Allocation Plan from SBI Life Insurance, even reallocate the corpus based on the life stage of the policyholder. A young person may have a bigger portion of his corpus invested in equities, but as he grows older the plan gradually shifts funds from equity to debt.

Advantages

1. Investors can switch between stocks and debt
2. All income (short-term and long-term) is tax-free
3. Short lock-in of 3 years

Drawbacks

1. Initial charges of 30-40%
2. Returns and risk are market-linked
3. Lucrative in the long term
4. Can't switch insurers

Best Suited For

Pro-active investors who want to rebalance investment portfolios without attracting capital gains tax.

LIFE INSURANCE

Should be bought for protection, not to save tax | Maximum limit: Rs 1 lakh
High-cost, low returns
Scheme Traditional Policy Term Plan-PPF Combo

Endowment Plan Term Plan PPF
Premium 12,000 3,500 8,500
Insurance cover 3 lakh 10 lakh Nil
Corpus on maturity 9 lakh Nil 10 lakh
Premiums for a 30-year-old for 30-year plans.
The term plan-PPF combo gives you a higher cover and a bigger corpus on maturity.

The fourth quarter is a busy season for insurance companies. That's when they conduct almost 35% of the total business for the year. Till a few years ago, this figure was as high as 50%, clearly showing that customers were buying insurance policies not as a risk cover but as tax-savers. The tax benefits on a policy are meant to reduce the cost of life insurance. They should not be seen as an end in themselves.

Buying a policy only to save income tax defeats the purpose of life insurance and leads a person to make a sub-optimal choice. The premium will be the deciding factor, not the cover he gets from the policy.
Tips
If you have paid premiums for at least three years, you can surrender the insurance policy.
But surrender value is very low in the inital years. You may get only 30% of the premiums paid.
A better idea is to convert it into a paid-up policy. The cover continues but premiums stop.

If you must have insurance in your tax-planning basket, traditional plans such as endowment or money-back policies are not a great idea. As the table shows, a term plan-PPF combo is better.

However, if you already have a policy, you may have no choice but to continue with it till the end of the term. You could surrender it if you have already paid the premiums for three years, but the surrender value is very low and you may get only 25-30% of the premiums paid. If only a few years are left for the policy to mature, don't surrender.

A better option is to convert the plan into a paid-up policy. This means the life cover continues but you stop paying the premium. This amount gets deducted from the policy corpus every year.

Advantages

1. Provides life insurance cover
2. Forces you to save
3. All income received is tax-free

Drawbacks

1. Traditional policies offer low cover at high premium
2. Returns are low
3. Gives false confidence of adequate insurance

Best Suited For

Investors who already have traditional insurance policies; not a good option to begin now.

PENSION PLANS

Planning for retirement | Maximum limit: Rs 1 lakh

The rising cost of living, higher life expectancy and the breakdown of the joint family system have made it imperitive to include a pension product in every financial plan. But the days of the defined pension benefit are over and we are now in a defined contribution regime, where our pension will depend on what we accumulate through the years.
Tips
If you do not get gratuity, up to 50% of the pension corpus can be commuted.
The New Pension Scheme to be launched this year will be open to non-government workers also.
Pension funds will soon be allowed to invest in more lucrative options.

The good news is that even if your employer does not offer you a pension plan, you can buy one from an insurance company. What's more, unit-linked pension plans offer greater transparency and control to the investor. One can choose a mix of equities and debt in the pension plan depending on one's risk appetite.

We must put in a word of caution here. If you are saving for retirement, don't take too much risk with the money. "If someone who is retiring this year had invested his money in an equity option of a pension plan last year, he would have been pauperised," says Vikas Vasal, executive director, KPMG. A balanced option, where the corpus is divided between equities and debt, is best.

A unit-linked pension plan is not as costly as a Ulip because it does not offer life insurance. But there are other things that an investor needs to keep in mind. On maturity, only 33% of the corpus can be withdrawn and is tax-free. The balance has to be used to buy an annuity from any insurance company, which will give a monthly pension. Incidentally, this pension is taxable.

Some mutual funds also offer pension plans. In most plans, the money cannot be withdrawn before the investor turns 58. Even if early withdrawals are allowed, you have to pay a penalty. The Templeton India Pension Plan, for instance, charges a hefty 3% exit load on amounts withdrawn before the vesting age of 58.

Advantages

1. Creates a long-term retirement cushion
2. No tax on 33% of corpus commuted on maturity
3. Not bundled with life cover

Drawbacks

1. Locks up money for the long term
2. Balance 66% of the corpus has to be put in annuity
3. Pension is taxable

Best suited for

Long-term investors who are not covered by the Employee Provident Fund or any other pension scheme.

HOUSING LOAN REPAYMENT

Reduces the cost of the loan | Maximum limit: Rs 1 lakh
Principal Advantage
Year Principal Repaid Tax Benefit*
1 58,175 17,453
2 64,906 19,472
3 72,417 21,725
4 80,798 24,239
5 90,148 27,044
6 1,00,579 30,000
7 1,12,218 30,000
8 1,25,207 30,000
9 1,39,694 30,000
10 1,55,858 30,000
*Assuming investor's income is in 30% tax bracket Rs 10 lakh loan at 11% for 10 years.
A major part of the Section 80C exemption is taken care of by the home loan repayment. The tax benefit will go up if the Rs 1-lakh limit is raised this year.

Three years ago, the interest rate on a home loan was around 8%. Now, it is 11.5%, which means an increase of almost three years in the loan tenure. You can either prepay a part of your loan or increase the EMI amount if you want to reduce the tenure. You might be tempted to increase the EMI amount, but then, that's likely to eat into the money you've set aside to invest in tax-saving schemes. Here's how you can have your cake and eat it too.
Tips
Take a joint loan with spouse, sibling or parent. This way, both co-owners of the property can separately claim tax benefits on the home loan.
Don't let the tax breaks tempt you to extend the tenure of your home loan. The shorter the tenure, the better it is.

The principal portion of a home loan EMI is eligible for deduction under Section 80C. As the table shows, your repayment of a Rs 10-lakh loan takes care of a sizeable chunk of the Section 80C limit in the first few years. By the sixth year, it completely does away with the need for any further tax-saving investments. So, even if you don't have surplus money to invest, your home loan repayment ensures that you don't lose out on Section 80C benefits. If you factor in this tax benefit and the deduction available under Section 24 on the interest paid on the home loan, the effective rate of interest comes down significantly.

What do you do if the principal repaid in a year exceeds the Rs 1-lakh limit under Section 80C? This is quite common because the average loan amount disbursed by the State Bank of India has risen from Rs 5.5 lakh in 1998 to almost Rs 18 lakh now. In such cases, it might be a good option to take a joint loan (preferably with a working spouse or even with a sibling or parent). That way, both co-owners can separately claim the tax benefits available on the home loan.

What many people don't know is that even the amount spent on stamp paper and registration of the property is deductible under Section 80C. That brings down the effective cost of the property itself.

Some investors let the tax breaks available on home loans guide their decision on the tenure of the home loan. They keep the EMI low and extend the tenure to claim as much tax benefit as possible. However, they overlook the fact that the interest cost sometimes outweighs the tax benefits.

THE TAX SLABS
Your investments under Section 80C are fully deductible from your taxable income. Find out your tax liability after the tax deduction.
Male taxpayers
Female taxpayers Senior citizens
Annual Income Tax Rate Annual Income Tax Rate Annual Income Tax Rate
Up to Rs 1.5 lakh Nil Up to Rs 1.8 lakh Nil Up to Rs 2.25 lakh Nil
Rs 1.5 lakh to Rs 3 lakh 10% of income above Rs 1.5 lakh Rs 1.8 lakh to Rs 3 lakh 10% of income above Rs 1.8 lakh Rs 2.25 lakh to Rs 3 lakh 10% of income above Rs 2.25 lakh
Rs 3 lakh to Rs 5 lakh Rs 12,000 + 20% of income above Rs 3 lakh Rs 3 lakh to Rs 5 lakh Rs 12,000 + 20% of income above Rs 3 lakh Rs 3 lakh to Rs 5 lakh Rs 7,500 + 20% of income above Rs 3 lakh
Above Rs 5 lakh Rs 52,000 + 30% of income above Rs 5 lakh Above Rs 5 lakh Rs 52,000 + 30% of income above Rs 5 lakh Above Rs 5 lakh Rs 47,500 + 30% of income above Rs 5 lakh
There is also a 3% education cess on the payable tax and a 10% surcharge on the total tax if the income exceeds Rs 10 lakh a year.

TUITION FEES

Tax sops on a necessary expense | Maximum limit: Rs 1 lakh
Tips
Tax benefit only on tuition fees paid to a recognised educational institution in India.
Playschools and private coaching classes not covered.
Benefit only for fees paid for two children of the individual.
Both spouses cannot avail of the benefit for the same child.

School and college fees seem to be rising inexorably, but there's no way you're going to compromise on your child's education, is there? Here's something to make those exorbitant fees a little less bothersome: you can claim tax benefits under Section 80C for tuition fees for up to two children. But remember, the tax benefits are only for fees paid to recognised educational institutions in India; playschools, foreign colleges and universities and private coaching classes do not qualify for the deduction.

Besides, the tax benefit is available only on the tuition fees and not on other charges or expenses. So capitation charges, admission fees, transport, etc, are also ruled out. Most importantly, the fees have to be for the taxpayer's own children and not siblings, nephews, nieces or grandchildren.

The other point that must be kept in mind is that this particular benefit cannot be availed of by both the parents. If there's only one child, only one of the parents can claim the tax benefits on the school tuition fee. Otherwise, each parent can claim the tax benefit for different children.