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  Tax queries answered by Dilip Lakhani, Senior Chartered Accountant

How liquid are your tax investments?
January, 25th 2016

It is that time of the year when you rush to invest in tax saving instruments. Under Section 80 C, you are allowed deduction up to ?1.5 lakh for certain investments made from your total income.

As a thumb rule, many of us compare returns before choosing an investment. But while returns matter, equally critical is liquidity, or the ease with which you can withdraw money from the instrument. Different tax saving instruments have different lock-in periods and withdrawal rules.

Here’s how you can trade off one (returns) for the other (liquidity) depending on your risk profile and time horizon.

Long-term, but risk averse
The Public Provident Fund (PPF) has been one of the most popular savings schemes, with its coveted EEE (exempt-exempt-exempt) status. The initial investment is eligible for tax deduction under Section 80C. The interest is also tax-free; so are withdrawals.

While the interest rate is in itself subject to change every year, it cannot be lower than long-term government bond rates.

Last year, the rates were fixed at 8.7 per cent. While the tax exemption at all the three stages pushes the yield up by more than the interest rate alone, the PPF does not score high on liquidity.

The investments are locked in for a period of 15 years and partial withdrawals are allowed only after the end of the sixth year. The amount that can be withdrawn is subject to limits based on the outstanding amount at the end of the fourth year. So, if you are risk averse and can part with your money for a fairly long period, the PPF is an ideal option.

Not for the long haul
If you are risk averse and have a shorter time horizon of, say, five years, then post office term deposit, NSC, and tax saving bank deposits are your choices. Interest on banks deposits as well as post office deposits is taxed at your slab rate.

With a bank deposit earning you on an average 7.5-7.75 per cent (best rate of 8.75 per cent offered only by one bank), the five-year post office deposit that offers 8.5 per cent is a clear winner.

The five-year NSC too offers 8.5 per cent. But, in case of NSC, the interest is considered reinvested and hence eligible for tax exemption. This pushes up the post-tax returns on the NSC, if you do claim that interest under 80C in the following year. So, NSC scores on the returns front.

However, if liquidity is your top priority, then post office term deposits are a far better option. In case of NSC, you can withdraw prematurely only in case of death, forfeiture by pledgee or through a court order.

Even then, the amount you can encash is calculated based on simple interest.

Five-year tax saving bank deposits rank even lower in terms of liquidity. This is because banks do not allow premature withdrawal of tax saving deposits. Post office deposits also have a lock-in period, but premature withdrawal is allowed with some compromise on returns.

If a deposit is withdrawn prematurely after six months but before expiry of one year from the date of deposit, simple interest at the lower rate applicable to Post Office Saving Account will be paid.

If deposits are withdrawn after the expiry of one year, interest will be paid for the completed period, perhaps at a lower rate than that specified.

However, in all cases, remember that the exemption claimed under Section 80C will be withdrawn if you pull out money before five years. Both the amount withdrawn and the interest accrued will be liable to tax.

So, if you are willing to take on market risk and invest in ELSS and ULIPs for tax purposes, how do these options fare on liquidity?

For the risk-taker
It is well known that ELSS offered by mutual funds that invest in select stocks or sectors score better on returns, than debt options discussed above.

Most top-performing ELSS have delivered 12-13 per cent returns over a five-year period. So, it’s definitely a deal maker when compared to the 8-9 per cent return on the humble post office schemes or bank deposits.

But unlike other equity funds that can be withdrawn at any point in time (tax treatments may vary based on short-term or long-term capital gains), ELSS have a three-year lock.

Also, do remember, in case of systematic investment plan (SIP), each instalment will be subject to a three-year lock-in from the date of investment.

But to be fair, three years is a fairly short lock-in when compared with five or more years of lock-in under debt options. It also offers more leeway when compared to ULIPs.

Investors can withdraw from ULIPs only after five years. Even so you will end up with meagre or negative returns.

This is because ULIPs carry a higher cost in the initial years. For the shorter period, ELSS works out to be a more cost-effective option.

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