Post elections it’s time to focus on the first complete Union Budget under the new government. For the average citizen of our country, the budget holds one point of interest, announcements on income tax and other direct or indirect taxes that can impact our money.
Why are we so focused on taxes? In fact, most people will start their investing journey simply to save taxes. Nothing wrong with that provided you do evolve over time and are able to move beyond this obsessive goal to save taxes and actually focus on creating efficient long term wealth.
The tax saving obsession
Saving taxes however, makes us feel a lot more accomplished because the tax saving happens now, today. It’s what we call instant gratification. This term literally is defined as the tendency to forego a future benefit in order to obtain a less rewarding but more immediate benefit. Tax saving investments which are not well thought through are just that.
It’s not your fault that you cannot not see the folly of your ways in picking instant gratification over future benefit. It’s innate human behaviour. It is the reason we are struggling with climate change, because we are unable to visualise the negative impact of our adverse environment choices today over the immediate convenience of continuing to do what we do. The actions which are causing this are easier and bring us more immediate satisfaction, like using plastic or cutting down forests to accommodate a housing project.
Instant gratification is also the reason for a lot of lifestyle linked obesity. The immediate satisfaction of eating sugar and salt laden junk food blinds us to the long term adverse health effects of our actions. Similarly, the lack of instant gratification keeps many of us away from a regular exercise regimen.
You get the point. Coming back to your money, investing and taxes. While it is good practice to focus on saving tax and thankfully our government has still kept a few ways open to do so within our income tax umbrella, basing an investment decision purely on tax saving is not a wise thing to do.
The first thing you must be conscious of, is understanding that when it comes to investing, long term wealth creation happens more by choosing the right asset and remaining invested for years at a stretch, rather than by saving taxes in your annual tax returns.
Let me explain. Our go to tax saving tool is a life insurance policy. You feel like you are getting the twin advantage of having insurance and saving taxes. The income tax section under which you can avail a tax deduction for annual premium paid towards a life insurance policy is Sec 80 C. This section also has other tax saving options like Public Provident Fund (PPF) and the Equity Linked Savings Scheme (ELSS) which is a mutual fund, to name a few.
Now the limit of tax saving investments that can be made under Sec 80 C is up to ₹1.5 lakhs. Tying up this much in an insurance policy premium means you have to either invest in a traditional life insurance policy like an endowment or a money back or you can invest in a Unit Linked Investment Plan.
With the former, you are unlikely to get an investment return of more than 5%-6% over your policy term (this is not what will be showcased to you, but it is the experience for the last many decades); this long term return fails to beat inflation.
With the latter, you are going to be unaware of how costs like mortality costs and insurance related costs will impact your overall return, till after it happens, moreover it is not flexible and you will have to lock in for at least five years. Both of course need you to clear a medical test and your policy premium can even be adversely impacted based on your health.
Now, an alternative to the above is the mutual fund based ELSS which has historically delivered post fee, inflation beating returns and compounded wealth over 10-15 year kind of investment periods, at a known 2%-2.5% annual cost or the PPF which, albeit, has a slightly lower return at 7.1% compared to ELSS, but also, it offers tax free interest income.
For someone who is interested in saving tax and creating an efficiently growing corpus for the future, both these tax saving options can be considered. You make up a lot more in returns than what you save in taxes, just by making a more efficient investment choice. In this case, anyway the tax saving is comparable.
The way forward
To be in a position to evaluate these two and then make the choice to opt for these above the more popular insurance options, you will have to give up two of your behaviour biases. Firstly, look beyond the instant gratification of tax saving and also consider the future benefit of your investment choice. Ask the right questions from the agent who is selling the tax saving investment to understand the future payoffs and investment return better.
Secondly, don’t look for a free lunch. There is no two in one status of an investment product which can deliver better performance than a pure investment product. Yet, when we are told you will get two things in one, insurance and investment, we think that we are making a wise choice.
Historically, simple equity funds have delivered returns in the range of 12%-14% for a 10-15 year period. This is much more than what a 20 year traditional insurance policy will make for you. It is also more than 7%-7.5% that investments like PPF, National Savings Certificate and so on deliver for a 10-15 year period. The higher return from equity linked investments is in a way a compensation for the near term volatility, but the key is to remain invested.
Hence, if in the subsequent Union Budget the government were to do away with incentives around financial products to save taxes, had you been making an efficient investment choice, the lack of tax saving would not matter as much.
Thus, while listening to the budget announcements this year, keep in mind that investing wisely can deliver returns which are superior to investments earmarked solely with the purpose of tax saving.
Lisa Pallavi Barbora is a financial coach and founder of moneypuzzle.in
