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Tax-saving options: Which is the best instrument under Section 80C?
January, 06th 2015

Budget 2014 gave taxpayers plenty to smile about. For instance, the hike in deduction limit under Section 80C meant that those who saved more could reduce their tax by up to Rs 15,000. While a higher limit can clearly be a boon for taxpayers, it may not be of much use if you don't know which tax-saving option suits you best. If you too are confused by the wide range of options under Section 80C, our cover story can help you. We have considered nine of the most common tax-saving instruments and ranked them according to their score on six parameters. All the options were graded on the basis of returns, safety, liquidity, flexibility, taxability of income, and cost of investment. Then they were ranked according to their composite scores.

Tax-saving options: Which is the best instrument under Section 80C?

Tax-saving options: Which is the best instrument under Section 80C?Not unsurprisingly, the equitylinked saving schemes (ELSS) or tax planning mutual funds hold the pole position this year, followed by Ulips. The PPF, which was ranked number one last year, has slipped to the third position, not because of any change in its features, but because products such as ELSS and Ulips hold greater promise in the current market conditions.

Not much has changed for traditional insurance policies as well as pension plans from insurance companies. They continue to be the worst ways to save tax. Even so, the tax planning season is a hectic time for agents, who sell lowyield insurance policies and high-cost pension plans to gullible investors. We hope our story will help the taxpayers make more informed decisions and optimise their savings this year.

1) ELSS funds

ELSS funds are the showstopper this year, scoring 28 out of 30 points. Being equity schemes, they are low on safety, but score full points on all other parameters.

The returns are high, the income is tax-free, the investor is free to alter the time and amount of investment, the lockin period of three years is the shortest among tax-saving investments and the cost is only 2-2.5% a year. The liquidity is even higher if you opt for the dividend option, and cost is even lower if you go for the direct plans of these funds.

Tax-saving options: Which is the best instrument under Section 80C?Don't look at ELSS funds as one broad category. Within these, there are schemes with a large-cap orientation, making them more stable than others. Some have a midcap skew, which can be riskier than largecap funds but also have greater potential. The funds that have lined their portfolios with small- and mid-cap stocks will be riskier, but can outperform by miles if the small-caps turn out to be multibaggers. The Reliance Tax Saver fund has almost 70% of its portfolio in smalland mid-cap stocks. It has outperformed the category in the past three years, churning out 41% returns when the category average is 27.7%.

Most of these returns have been generated in the past 16 months. Between December 2011 and August 2013, Reliance Tax Saver was just another tax-saving fund with an annualised return of 9%. Since then, it has shot up 93%, compared to the 55% rise in the average ELSS fund. Invest in such turbo-charged schemes if you want high returns but beware of the gutwrenching volatility.

Investors seeking stability can opt for large-cap funds, such as Franklin India Taxshield, ICICI Prudential Tax Plan and Axis Long Term Equity Fund. These move in line with the broader market and can be part of the core equity portfolio.

A few caveats here. While ELSS funds have generated spectacular returns in the past few years, tone down your expectations in the coming years. Equity schemes do well when the market rallies, but suffer when the bears return. These can carry a slightly higher risk because the exit route is blocked.

Once you invest, you cannot withdraw your money before the lock-in period of three years. This is why you should have an investment horizon that is longer than this. "Equities can be slightly risky over a three-year term as one business cycle takes 2-3 years to play out. So, in three years, one can get caught on the wrong side of the cycle," says Delhi-based financial planner Amit Kukreja.

Tax-saving options: Which is the best instrument under Section 80C?

2) ULIPs

Tax-saving options: Which is the best instrument under Section 80C?For a lot of people, Ulip is still a four-letter word. However, investors need to wake up to the new reality. After Irda capped the charges and introduced new rules for Ulips in 2010, these plans have become more customer-friendly. An ordinary Ulip is still a costly proposition, but the online avatar of these market-linked insurance plans is a low-cost version far removed from the one missold to investors a few years ago. The Click2Invest plan from HDFC Life, for instance, charges only 1.35% a year for fund management. The only other deduction is mortality charge for the life cover, while the rest of the premium is invested. The i-Growth plan from Aviva Life Insurance charges 1.21% a year for a 20-year policy with an annual premium of over Rs 1 lakh.
While the low charges are a big advantage in the long run, experts say one should not go by cost alone. "Don't buy a Ulip only because it has low charges. The performance of funds should also be taken into consideration," says Deepak Mittal, CEO of Edelweiss Tokio Life Insurance (see interview). That's true. If you save 2-3% on cost by investing in an online plan, but the funds underperform by 4-5%, you will be a net loser.

According to Morningstar, Ulips have not done too badly in recent years. Ulip funds with an aggressive allocation (50-75% of the portfolio in stocks) have risen 28% in the past year (see graphic).

Tax-saving options: Which is the best instrument under Section 80C?
However, these returns reflect only the rise in the fund's NAV. The returns for the investor may be lower because some of the monthly charges levied by Ulips are by deduction of units. So, if you started the year with 5,000 units of a fund with an NAV of Rs 20, your corpus would be Rs 1 lakh. If the NAV rises to Rs 25 by the end of the year, your returns may not be 25% because some units may have been deducted. If 100 units have been deducted, your returns will be lower at 22.5%. Keep this math in mind when looking at the returns from Ulips.

Even so, these can be used as a rebalancing tool by the savvy investor. The switching facility in a Ulip allows the policyholder to switch from equity to debt, and vice versa, based on his reading of the market. There is no tax implication on such switches and the process is fairly simple. Online access has made it even easier.

Though financial planners frown on this combination of insurance and investment, they feel that Ulips are a better option for those who are reckless with money. "If a spendthrift invests in an ELSS fund, he is likely to withdraw after the lock-in period and blow it away. Ulips have a lock-in period of five years and one is forced to invest every year," says Mumbai-based financial planner Steven Fernandes.

Buy a Ulip only if you can pay the premiums for the full term and take one for at least 15 years. A short-term plan may not help recover the high charges in the initial years.

3) Public Provident Fund

Tax-saving options: Which is the best instrument under Section 80C?When Budget 2014 raised the deduction under Section 80C from Rs 1 lakh to Rs 1.5 lakh, it also hiked the annual investment limit in the Public Provident Fund (PPF). Risk-averse investors can now sock away more in this ultra-safe scheme.

The PPF scores high on safety, taxability and costs, but the returns are not so attractive and liquidity is not very high. The scheme will give 8.7% this year, but don't count on it in the following years. The interest rate on small savings schemes like the PPF is linked to the government bond yield and it is likely to come down in the coming years.

Though it is a 15-year scheme, the money isn't locked for this period. You can make partial withdrawals from the sixth year or take a loan. The interest rate on a loan is 2 percentage points higher than the prevailing PPF
interest rate. For 2014-15, the rate will be 10.7%. Besides, the lock-in period depends on how long ago you opened the account. For those who started investing in the PPF 10-12 years ago, the effective lock-in period will be only 3-5 years.

Tax-saving options: Which is the best instrument under Section 80C?
You can extend your PPF account for blocks of five years even after the scheme matures. An account can be opened in a post office or at designated bank branches. Some banks even give online access to the PPF account. It's a useful feature that will reduce the effort to invest in the scheme.

4) Voluntary PF

Tax-saving options: Which is the best instrument under Section 80C? Investors love the PPF because they get a tax deduction on the amount they invest. There is no tax on the interest earned and withdrawals are also tax-free. The only glitch is the annual investment limit, which has now been hiked. However, another instrument gives almost the same returns and tax benefits without imposing any investment limit.

Salaried taxpayers who are covered by the Employees' Provident Fund can put more than the mandatory 12% of this basic in the Voluntary Provident Fund (VPF). "The VPF is an ideal saving instrument for high-income earners looking to build a taxfree corpus. Unlike the PPF, there is no limit on how much you can invest," says Central Provident Fund Commissioner K.K. Jalan.

The contributions to the VPF are eligible for tax benefits that the Provident Fund enjoys. They also earn the same interest (8.75% for 2014-15). Unlike the PPF, its returns are not linked to the market but decided by the Central Board of Trustees of the Employee Provident Fund Organisation in consultation with the government. However, the VPF scores low on liquidity. You can't access money till you retire.

A one-time withdrawal is allowed in special circumstances—medical emergency, purchase or construction of a house, or a child's marriage. As with EPF, money withdrawn within five years of joining service attracts tax at the applicable marginal rate.

For some taxpayers, this may not be an option now. Typically, employees have to inform their employers about deducting VPF at the beginning of the financial year. If you have opted for the deduction, you can't discontinue till the end of the financial year.

Experts advise this option to those nearing retirement and face a shortfall.


Tax-saving options: Which is the best instrument under Section 80C?The Senior Citizens' Saving Scheme (SCSS) is an ideal tax-saving option for senior citizens above 60. The money is safe, while the returns and liquidity are reasonably good. There is an investment limit of Rs 15 lakh but it is sufficiently high. However, the interest income from the scheme is fully taxable.

The other problem is that even if you have a large amount to invest, the maximum deduction will be Rs 1.5 lakh a year. You can stagger your investments across 2-3 financial years to make full use of the deduction under Section 80C. You can open an SCSS account in a post office or designated branches of public-sector banks. The interest is linked to the government bond yield. It is 1 percentage point higher than the 5-year government bond yield. Unlike the PPF, the rate remains unchanged till maturity.

Tax-saving options: Which is the best instrument under Section 80C?

6) NPS

Tax-saving options: Which is the best instrument under Section 80C?More than five years after it was thrown open to the public, the New Pension Scheme (NPS) is yet to become a popular choice.

Despite very low charges, the scheme has not attracted investors in droves because of the complex procedure involved in the opening of an account. You have to literally beg the post office staff to get the paperwork done. In bank branches, the investor himself has to guide the staff on the basics of the NPS.

However, the investors who have managed to cross these barriers have found it rewarding. The NPS funds have not done badly in the past five years. The returns from the E class funds are in line with those from the Nifty, the benchmark index they are supposed to follow. It is the corporate bond funds that have been the best performers in the past five years. Even the gilt funds have given reasonably attractive returns (see graphic).

Some financial planners believe that the NPS puts the investor in a straitjacket. The exposure to E class (equity) funds cannot be more than 50%. That is too conservative, especially for the young people who want to stay invested for longer periods and prefer a higher exposure to equity.
Tax-saving options: Which is the best instrument under Section 80C?

While this is a major drawback, the NPS is flexible in other ways. It allows investors to rejig their asset allocation and even change the pension fund manager once a year. In a pension plan or Ulip, you cannot change from one company to another without terminating the plan.

The other sore point is the lack of liquidity and taxability of income. The investment is locked up till the investor turns 60 years old. Before this age, a subscriber can withdraw only 20% of the corpus and use the balance 80% to buy an annuity. If he waits till he turns 60, up to 60% of the corpus can be withdrawn and the balance 40% would be annuitised. However, unlike pension plans from insurance companies, the amount withdrawn will not be tax-free. The annuity income will also be fully taxable.

The NPS also offers a feature of lifecycle fund. It is meant for those who are not financially savvy and can't manage their asset allocation themselves. It is taken as the default option for someone who has not indicated the desired asset allocation. Here, the asset allocation is driven by the investor's age. The 50% equity allocation reduces by 2% every year once the investor turns 35, till it touches 10%.

The NPS also offers tax benefits, besides the deduction under Section 80C. Contributions of up to Rs 1 lakh in a year made by an employer on behalf of an employee are eligible for additional deduction under a new Section 80CCD. The contribution under this section is limited to 10% of the salary (basic plus dearness pay).

However, not all NPS investments are locked up till you retire. The investments in Tier II accounts can be withdrawn anytime. Some investors look at Tier II accounts as low-cost mutual funds. However, the low cost alone should not be the reason to invest in these funds.

7) Bank FDs and NSCs

Tax-saving options: Which is the best instrument under Section 80C?The five-year bank deposits and NSCs score high on safety, flexibility and costs, but the tax treatment of income drags down the overall score. The interest rates are a tad higher than those offered by the PPF, but the income is fully taxable at the slab rate applicable to the individual. So bank deposits and NSCs are best suited to taxpayers in the 10% bracket (taxable income of less than Rs 5 lakh a year).

The five-year bank deposits and NSCs are also very liquid. If faced with a cash crunch, you can use them as collateral to raise a loan. The biggest advantage is that these are widely available. Just walk into any bank branch and invest in its tax-saving fixed deposit. Of course, you will have to comply with the KYC norms while doing so.

If the interest income exceeds Rs 10,000 in a year, the bank will deduct TDS. Some investors try to avoid the TDS by splitting their investments across 2-3 banks. This is not a good idea because one has to pay tax on this income. In fact, the TDS is only 10% on the interest earned. If the taxpayer is in the higher income slab, he will have to pay additional tax.

Tax-saving options: Which is the best instrument under Section 80C?

This is not something that you can sweep under the carpet. Tax authorities sniff out such cases when they pick up income-tax returns for random scrutiny. If your tax return is picked up for scrutiny, the tax department might want to know why the income from the tax-saving deposits (for which you claimed deduction under Section 80C) has not been included in your total income. If TDS has been deducted, it will reflect in your Form 26AS, so don't even think of ignoringthis income in your tax return.

Those in the lower tax brackets can build a ladder of tax-saving FDs and NSCs. Just reinvest the maturity amounts in fresh tax saving deposits. After the fourth year, your tax planning will be taken care of by the maturity proceeds of the deposits.

8) Pension Plans

Tax-saving options: Which is the best instrument under Section 80C?Though the insurance regulator has rectified the cost and commission structure of Ulips, pension plans from insurance companies remain costly investments that are best avoided. In the past year, the returns from the equity funds of pension plans have been close to 25%. However, as we mentioned earlier, this is only the change in the NAV. The net return for the investor may be lower because some charges are levied by deducting the units from the account.

Instead of the pension plans from insurance companies, it may be a better idea to go for the retirement funds from mutual funds. They give the same tax benefits but don't force the investor to annuitise the corpus on maturity. He is also free to remain invested beyond the age of 60.

Since these mutual funds are debtoriented plans, the investor can claim long-term indexation benefit when he withdraws. In the long-term, the inflation indexation can reduce the tax to almost nil. Unfortunately, there are very few funds in this space. Late last month, Reliance Mutual Fund launched its Reliance Retirement Fund, an equity-oriented fund that is eligible for tax deduction under Section 80C. Sebi wants fund houses to launch more such funds. If more retirement funds are introduced and the government extends them the same tax benefits, they can become game changers for the pension plan category.

However, your retirement planning should not hinge on the launch of pension products. This purpose can be fulfilled by other products, such as ELSS schemes and diversified equity funds, as well. In fact, as we explained earlier, even Ulips can be used for this purpose.

9) Life Insurance Policies

Tax-saving options: Which is the best instrument under Section 80C?Agents like to project traditional insurance plans as instruments that offer triple benefits: life insurance cover, longterm savings and tax savings.

The reality is quite different. Traditional policies are not the best form of life insurance. A term plan can give a 10 times bigger cover at a fraction of the cost. Nor are they a good investment because the returns are barely 5-6%. But they are certainly the worst way to save tax. They require a multi-year commitment and are not very liquid.

Last year, the insurance regulator tweaked the charges on traditional insurance plans and introduced some customer-friendly rules. Traditional products will now offer an insurance cover of at least 10 times the annual premium. The surrender value will depend on the premium paying term of the policy and the minimum surrender value now stands at 30% of all the premiums paid.

Tax-saving options: Which is the best instrument under Section 80C?
Despite these changes, the plans don't qualify as good investments. The only benefit is that the income is tax-free, but then, so is the income from the PPF and taxfree bonds. Another positive feature is that you can easily get a loan against such policies.
Don't be lured by limited premium plans
The shorter term only means you will pay a higher premium.

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