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Understanding tax inefficient instrument
December, 29th 2014

There are many tax inefficient instruments that are available in the market. Many people invest in them which ends up being a drag as far as the overall tax planning efforts are concerned. The question that most people grapple with is what is the meaning of tax inefficiency and how can one actually understand that they are faced with such a situation. This is crucial because once the problem is identified then the individual can ensure that he stays clear of these and choose more appropriate investments which are actually suitable for his tax saving requirements. Here is a closer look at how this can be defined for easier use by the individual.

No tax deduction

One of the tax benefits that a lot of investments possess is that they provide a tax deduction to the individual when the amount is actually invested. The deduction is nothing but a reduction of the taxable income of the individual so that the final base for the calculation of the taxes is low. This ensures that they are getting a tax relief every time the investment is made. A lot of people actually end up not completing the total deduction limits that they are eligible for under the Income Tax Act and this can lead to a missed opportunity. This is the first step in which the inefficiency starts. However one has to understand that not all instruments will have a tax deduction and just because this is absent does not mean that the investment is not suitable for the individual. This kind of analysis is valid only when one is looking at the investment efficiency from the tax point of view and not when evaluating it from the overall suitability point of view where the tax benefit does not matter or is not primary in the whole scheme of things.

Earnings are taxable

Another way in which the inefficiency creeps into the tax aspect is that the earnings that are given by the instrument are actually taxable in the hands of the individual. This would mean that there is no tax relief of any kind when the earnings are considered and this results in the full amount of the tax burden coming on them. There are several routes like tax free bonds on the debt front and long term equity holdings where the tax rate is zero and this can make a huge difference to the final rate of return that is actually earned by the individual especially for those who fall into the higher tax brackets. Most instruments will have their earnings taxable but this does not make them unfit for selection but one has to see carefully the kind of impact that these would have on the overall decision making process.

No cash outflow

There can be a double hit for the investor if the earnings are fully taxable and at the same time these are not paid out till the maturity of the instrument. This means that every year the individual would have to include the amount that is earned in their tax returns and actually pay tax on this amount while the earnings come into their hands years later when the instrument actually matures. This can lead to a mismatch in terms of the cash flow for the individual because they are forced to make the tax payment from other sources while the income is actually locked up for quite some time to come. This is another way in which inefficiency comes into the investment. At the end of the day just the presence of an inefficiency does not make an investment worthless but one has to ensure that all the conditions are considered carefully while making an investment especially when the aim is to save taxes.

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