This week’s cover story attempts to resolve these dilemmas for taxpayers. Like in the past, we have assessed 10 tax-saving instruments on eight key parameters—returns, safety, flexibility, liquidity, costs, transparency, ease of investment and taxability of income. Each parameter is given equal weightage and the composite scores of the various options determine their ranking.
The ranking alone is not a guide. We have also explained the pros and cons of each tax-saving option to help readers invest in the one that suits them best.
Our rating: 5 stars
Returns: 13.2% in past three years
ELSS funds score high on almost every parameter. They have the potential to give high returns, have the shortest lock-in period of three years, regularly disclose their portfolios and have fairly low costs. They are also very tax friendly—the 10% long-term capital gains tax kicks in only on gains beyond `1 lakh and regular harvesting of capital gains can reduce the liability to a great extent. What’s more, investing in these funds is very easy if you are already KYC compliant. It can be done online in a matter of minutes through all fund houses and the investing portals that have mushroomed in recent years.
However, the big worry for investors is that markets are at hyper inflated levels even as the economy is expected to shrink by 7.7% this year. The macroeconomic numbers raise questions about the sustainability of the rally that has taken benchmark indices to all-time high levels. Investing a large amount in equity funds at one go is not a good idea when the Nifty is trading at a PE of 40, especially when you can’t touch that money for three years.
Best performing ELSS funds
Returns are annualised; data as on 13 Jan 2020 Only funds with AUM of over Rs 1,000 crore considered Source: Value Research
Experts say that investors who stagger their purchases over time and invest with a long-term horizon need not worry. But staggering the amount across 2-3 monthly SIPs is not an option for taxpayers who have to show proof of Sec 80C tax-saving investments in a few days. Keep in mind that ELSS funds are essentially equity schemes and carry high risk. It’s best not to get carried away by the irrational exuberance sweeping through the stock markets.
Choosing the right fund is also critical. Many ELSS funds have done well in the past three years, but the category average is not very impressive. Also, don’t make the mistake of opting for the dividend option, which can push up your tax liability since dividends are now added to income and taxed at the normal slab rate.
2. National Pension Scheme
Our rating: 5 stars
Returns: 11-14.3% for past five years
NPS helps save tax under three different sections. Firstly, contributions of up to Rs 1.5 lakh can be claimed as a deduction under the overall Sec 80C. Besides this, there are two tax benefits exclusive to the NPS. There is an additional deduction of up to Rs 50,000 under Sec 80CCD(1b). Also, if the employer contributes up to 10% of the basic salary of the individual in the NPS under Sec 80CCD(2), that amount is tax free.
Apart from these tax advantages, the NPS allows investors to choose their as set mix (and even make changes) besides changing their pension fund manager. And its fund management charges of 0.01% (or Rs 10 per Rs 1 lakh investment) are perhaps the lowest among all market-linked instruments. In the long term, even a small difference in the costs can have a significant impact on the maturity corpus of the investor.
How NPS funds performed
Returns are annualised; data as on 13 Jan 2020
Source: Value Research
One problem is the long lock-in period. Except in case of specific emergencies, NPS investments cannot be withdrawn till the taxpayer attains the age of 60 or retires. Many taxpayers may not want to lock up their money for such long periods. The compulsory annuitisation of 40% of the corpus on maturity is another bugbear for investors, although many financial planners perceive this as a positive feature that ensures lifelong pension for the individual.
NPS funds have had a very good run in the past few years due to the twin rallies in stocks as well as bond markets. But while the equity markets are expected to correct, the decline in bond yields may now reverse. The long-term bonds held by gilt funds will lose value if interest rates go up. Experts say it is better to move from gilt funds, where the average duration of bonds is 8.2 years, to corporate bond funds, where the average duration is 4.5 years, making them less sensitive to interest rate changes.
Our rating: 4 stars
Returns: 8-12.5% for past three years
Ulips score high in our ranking because income from insurance plans is completely tax free under Sec 10(10d). But this tax exemption is subject to certain conditions being met. The insurance cover should be at least 10 times the annual premium. This tax-free aspect has become more significant after long-term capital gains from equity investments were made taxable two years ago. While gains beyond a Rs 1 lakh from equity funds are taxable, income from Ulips remains tax free. Moreover, switching from equity to debt or vice versa in a Ulip does not have any tax implications, making a Ulip an ideal instrument for rebalancing the portfolio.
But Ulips have their shortcomings as well. Their charges have come down drastically, but the structure is still opaque. Some of the charges are built into the NAV while others are levied by deducting units. Check all charges before you buy. Ulips also score low on flexibility. Once you buy, you are stuck with the same insurer for the rest of the term. You can’t switch to another insurer. Also, you have to continue paying the premium for a minimum period. Otherwise the plan is discontinued and the money returned after some deductions.
Ulips also continue to be mis-sold by banks and wealth managers. A person may think he is investing in a fixed deposit whereas he ends up making a multi-year commitment. Don’t sign any form without reading what it is all about.
4. Public Provident Fund
Our rating: 4 stars
Returns: 7.1% for Jan-Mar 2021 quarter
The PPF scores high on safety, flexibility and taxability. There is also ease of investment. An account can be opened in a Post Office branch or designated branches of PSU banks. Some private banks also offer the facility to invest in the PPF. The tenure of the scheme is 15 years from the first investment. On maturity, this can be extended in perpetuity in blocks of five years.
What investors must note is that small saving schemes have floating rates of interest. The interest rates are linked to government bond yields and are changed every quarter. The benchmark 10-year bond yield has been declining consistently and is now below 6%. But this is not reflected in the rates of small savings schemes, which have remained unchanged for three quarters. Unless interest rates move up and bond yields rise, the government will eventually have to cut small savings interest rates.
Financial advisers say the tax-free nature of the PPF makes it better than fixed deposits. However, they also point out that those covered by the Provident Fund could earn higher returns if they opt for the Voluntary Provident Fund. But that can be done only in the next financial year. For this year, go for the PPF. It is an investment in which you can’t ever go wrong.
5. Senior Citizens’ Saving Scheme
Our rating: 3 stars
Returns: 7.4% for Jan-Mar 2021 quarter
Although its rate is also linked to government bond yields, the Senior Citizens’ Savings Scheme (SCSS) offers a higher return than the PPF. Banks also offer higher rates to senior citizens for five-year tax-saving fixed deposits, but they cannot match the SCSS. The tenure of the investment is five years, which is extendable by another three years.
However, the eligibility is restricted to those above 60 years. In some cases, where the investor has opted for voluntary retirement and has not taken up another job, the minimum age is relaxed to 58 years. There is also no age bar for defence personnel. They can invest in the scheme even before 60 as long as they satisfy the other requirements. Also, there is a Rs 15 lakh overall investment limit per individual. These rules have narrowed down the eligibility and brought down its overall score in our ranking.
Even so, the SCSS is by far the best investment option for those above 60. The additional tax exemption for interest up to Rs 50,000 for senior citizens makes the scheme even more attractive. An account can be opened in a Post Office or at designated branches of banks. It is better to open an account with a bank. Operating it will be less cumbersome.
6. Sukanya Samriddhi Yojana
Our rating: 3 stars
Returns: 7.6% for Jan-Mar 2021 quarter
The Sukanya Samriddhi Yojana is offering the highest rate among all small savings schemes. Just like the PPF, the interest earned is tax free and there is an annual cap of Rs 1.5 lakh on the investment. Accounts can be opened in any post office or designated bank branches with a minimum investment of Rs 1,000.
But the scheme is open only to taxpayers with a daughter below 10 years. A parent can open an account for a maximum of two daughters, but the combined investment in the two accounts cannot exceed Rs 1.5 lakh in a year. If the annual limit is exceeded, the amount in excess of Rs 1.5 lakh will not earn any interest. What’s more, even if this discrepancy is noticed several years later, the interest earned by the excess amount will be reversed. So it’s best to stick to the rules.
Incidentally, the account is opened in the name of the child and the maturity proceeds have to be used for her education and marriage. Keep in mind that the interest rate will change every quarter, though it has remained unchanged for three quarters despite a consistent fall in bond yields. It seems unlikely that the government will cut rates in this surcharged political environment.
7. Pension plans
Our rating: 3 stars
Insurance companies want that their pension plans should also be eligible for the additional tax deduction of Rs 50,000 available to NPS under Sec 80CCD(1b). They have been lobbying with the Finance Ministry for several years but to no avail. Though this is unfair to the industry, it is unlikely that the coming budget will curtail the exclusive tax benefit enjoyed by the government-sponsored NPS.
The pension plans from insurance companies also cannot match the low costs and flexibility of the NPS. The NPS charges only 0.01% (or Rs 10 for Rs 1 lakh) per year for fund management while the pension plans charge almost 1-2% (or Rs 1,000-2,000 per Rs 1 lakh) per year. Besides, like Ulips, these pension plans have opaque structures and many of the charges are not very clearly explained to the buyer.
The NPS also allows the investor to shift from one pension fund manager to another if he is not satisfied with the service or the performance. But in case of a pension plan, the investor is tied to the company till the plan matures. Of course, the taxability of the annuity pension is a problem that both pension plans and the NPS have to contend with.
Our rating: 2 stars
Returns: 6.8% in Jan-Mar 2021 quarter
The National Savings Certificates (NSCs) have slipped in the ranking due to the steep cut in interest rates. When the interest rates of small savings schemes were cut in April 2020, the NSCs got the unkindest cut of 1.1 percentage points. Even so, the NSC rate is still marginally higher than what banks are offering on their tax-saving fixed deposits.
The positive features of NSCs is the assured returns, a short lock-in of five years and the flexibility of investment. The NSCs are government-backed instruments and the interest rate is guaranteed. Unlike the PPF, the money does not get locked up for several years. Also, you are not required to make a multi-year commitment as in case of insurance plans.
What’s more, the interest earned on the NSC is also eligible for deduction under Section 80C in the following years. Here’s how this works. Suppose an investor buys Rs 50,000 worth of NSCs in January 2021. One year later, the investment would have earned an interest of about Rs 3,750. The investor can claim deduction for this Rs 3,750 for the year 2020-21. The next year, the investment would earn about Rs 4,000 in interest. This can be claimed as a deduction in 2021-22.
NSCs can be purchased from any designated branch of the Post Office. In 2017, the government also allowed some banks to sell these instruments.
9. Tax-saving fixed deposits
Our rating: 2 stars
If NSC rates are low, bank fixed deposits rates are even lower. Making things worse is that bank interest is fully taxable, which brings down the post tax rate for investors in the 20% and 30% tax brackets. If the rate is 6.5%, the post-tax return is only 5.15% in the 20% bracket and only 4.47% in the 30% tax bracket. That is roughly the return the much denounced endowment insurance policies deliver.
Even so, tax-saving bank fixed deposits are a good choice for those who may have left their tax planning for the last minute and are now running around searching for the best investment option. If someone has to show proof of investment this week, all he has to do is log on to his Netbanking account. A few clicks of the mouse is all it takes to invest in a tax saving fixed deposit. This is possible 24×7 and from anywhere. Even if his bank has closed for the day or the investor has to go out of town, he can easily open a fixed deposit using Netbanking.
Senior citizen taxpayers who don’t want to stand in a queue in a Post Office will also find this useful. Please note that you cannot invest in a fixed deposit in somebody else’s name using your Netbanking account.
10. Life insurance policies
Our rating: 1 star
It is hardly surprising that life insurance policies are at last place in our ranking of tax saving options. ET Wealth firmly believes that life insurance is the lynchpin of a financial plan. It protects the goals of the individual even if he is not around. But we also believe that this purpose is best accomplished through a pure protection term plan. Term plans have no investment component so the entire premium goes towards mortality charges. They also cost a fraction of what you pay for a traditional endowment policy or a money back plan. A 30-year-old man can buy a cover of Rs 1 crore for 30 years by paying an annual premium of Rs 10,000-12,000 per year. In comparison, an endowment plan offering a cover of Rs 40-50 lakh will cost the buyer almost Rs 4-5 lakh per year.
Older people often pressure their children to buy insurance policies. Some people even buy one as a gift for their children when they start earning. They pay the first premium and then the child has to continue for the rest of the term.
This gift become a millstone around the neck of the recipient, yielding very low returns of 4-5.5% even though better and more lucrative options are available. If the child stops paying the premium, the policy lapses, leading to heavy losses. If the plan is surrendered, the policyholder is slapped with high surrender charges.
The only good thing about traditional insurance policies is the guaranteed returns and tax-free maturity corpus. But these benefits are far outweighed by the low returns and inflexibility of the instrument.