Tax planning: 7 characteristics to consider when choosing a financial product for investment

Tax planning: 7 characteristics to consider when choosing a financial product for investment

The tax benefit at the time of investment is only one factor to consider when selecting a financial product for investment. Other aspects of the product must be considered.

It is the fourth quarter of the fiscal year, and tax planning is in full swing. Most people are reminded to submit investment proofs by their finance department. You should also be looking for tax-saving financial products. However, when selecting a financial product for investment, the tax benefit at the time of investment is only one factor to consider. You must consider the product's other features to determine whether it meets your needs and then make an investment decision accordingly. Let's take a look at some of these characteristics.

1) Tax Treatment at Maturity or Redemption

Some products provide income tax benefits under Sections 80C, 80CCD, and so on at the time of purchase. It is also critical to understand the tax implications of redemption/maturity.

Assume, for example, that a 5-year tax-saving fixed deposit pays a 7% annual interest rate. The interest earned on a fixed deposit, on the other hand, is fully taxable (except for relief up to Rs. 50,000 for senior citizens under Section 80TTB). So, if you are a young or middle-aged person in the 30% income tax bracket, the 7 percent p.a. interest rate will be reduced to 4.9 percent p.a. after tax. Assume the Public Provident Fund (PPF) also pays 7% per year. The maturity proceeds of a PPF, on the other hand, are tax-free.

So, based on tax treatment at maturity, if we compare a 5-year tax-saving fixed deposit with PPF (assuming both offer the same interest rate), PPF emerges as the superior investment product.

Check the tax treatment of other financial products at maturity/redemption as well. The death benefit on a life insurance policy, for example, is tax-free in the hands of the nominee/legal heir. In the case of ELSS, the first Rs. 1 lakh of long-term capital gain (LTCG) in a fiscal year is exempt. The incremental LTCG is taxed at a rate of 10%.

2) Involved Risk

When selecting an investment product, consider whether the risk involved corresponds to your risk tolerance. An ELSS scheme, for example, must invest at least 80% of its total assets in equity and equity-related instruments. In the short term, equities are volatile. They are appropriate for investors with a high risk tolerance. As a result, ELSS is not suitable for conservative investors. Consider fixed-income products such as the Public Provident Fund (PPF), tax-saving fixed deposits, National Savings Certificate (NSC), and so on.

3) Annualized Rate of Return

If your expected rate of return from financial products is 10% CAGR or higher, you should think about investing in ELSS or NPS (choose equity asset class). If you choose to invest in debt products such as PPF, tax-saving fixed deposit, NSC, and so on, you will have to settle for returns in the single digits. The returns on debt products may or may not be sufficient to meet your financial objectives.

It is advised that you follow asset allocation by allocating appropriate amounts to domestic equity, international equity, debt, gold, and so on. It will assist you in diversifying your investment portfolio and earning the best risk-adjusted returns.

4) Investment Time Frame

Every tax-saving product has an investment period after which it can be redeemed or closed.

a) The ELSS has the shortest lock-in period, which is three years. An investor has the option of continuing beyond the three-year period or redeeming the units.

b) Both the NSC and the tax-saving fixed deposit have a 5-year term. Following maturity, the investor may withdraw or reinvest the funds.

c) The PPF has a 15-year term. Following maturity, the investor can extend the tenure in 5-year increments.

d) The NPS is valid until retirement (60 years). At maturity, the investor can withdraw up to a certain percentage of the accumulated amount (commutation) and use the remainder to purchase an annuity.

Keep in mind the timeframe for your financial goals when selecting an investment product for tax savings. If your financial goal is 5 years away, you may want to consider a 5-year tax-saving fixed deposit, NSC, or similar investment. Going for longer-term investment products, such as PPF, NPS, and so on, will be a mismatch with your 5-year financial goal.

5) Availability of liquidity

We discussed how the tenure of the financial product chosen for tax savings should match the investment time horizon for your financial goals in the previous point. You can divide your financial goals into three categories: short (less than three years), medium (3 to seven years), and long (more than seven years), and then choose the tenure of investment products accordingly.

However, you may have an urgent need to withdraw from your long-term investment at times. In such cases, please be aware that there are short-term solutions available to you. As an example:

a) After three years, you can withdraw from ELSS in part or in full, depending on your needs. You have the option to pause new investments at any time.

b) You can borrow money against your NSC by using it as collateral.

c) After a certain number of years, the PPF allows you to take a loan or make a partial withdrawal.

d) After a certain number of years, you can make a partial withdrawal from an NPS. The partial withdrawal can be up to a certain percentage of the total amount contributed. Finally, the money from the partial withdrawal can only be used for specific purposes. Some of these goals include child education and marriage, home purchase or construction, treatment of specific illnesses, and so on.

However, you cannot make a partial withdrawal or take a loan against a tax-saving fixed deposit. Check the liquidity options when selecting an investment product for tax savings.

6) Investment Minimums and Maximums

Check the minimum and maximum investment amounts when choosing a financial product for tax savings. The minimum investment amount for most financial products is usually between Rs. 500 and 1,000. It is affordable to the majority of people across all income levels.

The maximum investment allowed in a fiscal year for PPF is Rs. 1,50,000. There is no maximum amount that you can invest in a fiscal year in investment products such as EL7) Investing Ease

Aside from the investment limit, you should also consider the ease with which you can invest. For example, with ELSS, you can use a systematic investment plan (SIP). The specified amount will be deducted from your bank account at the specified frequency (weekly, monthly, etc.), and the equivalent units will be credited to your mutual fund account. You can also choose auto-debit for life insurance premiums. The frequency of auto-debit can be monthly, quarterly, half-yearly, or yearly.SS, NSC, life insurance, and so on. However, under Section 80C, the maximum deduction available in a fiscal year is limited to Rs. 1,50,000. Section 80CCD specifies the maximum deduction for NPS.

The National Savings Certificate and tax-free fixed deposits are both lump sum investment options. Every time you need to invest more money, you must buy a new NSC certificate or make a new fixed deposit. For each additional investment in the PPF, you must initiate a new transaction, either online or at the bank/post office.

Saving taxes when investing is a good place to start.

To summarise, when deciding to invest in a financial product, consider factors other than tax savings at the time of investment. Although tax savings is a good starting point, consider the financial product's other features. Match all of the features to your requirements and make your investment decision accordingly.