Personal finances and Tax

Why Tax Sops?

The government gives a variety of tax sops to encourage certain behavior. For instance, the tax savings under section 80 c gives tax benefits for savings up to Rs 1.5 Lakh per year. The idea is to get people to save and invest money. Similarly section 80 ccg gives tax benefits for investments of up to Rs 25,000 for people having income less than 12 Lakhs. The idea is to get small investors to invest in mutual funds so that they get good returns without inordinate risks.

Of course, sometimes the tax sops stop making sense. For instance, on a first self occupied house, a maximum of Rs 1,50,000 deduction is available. But on second or more houses, the deduction available is the entire interest less 70% of deemed rent. In the present scenario, with high interest, high property values and low rents, this second option may be several times the first limit. In other words, it gives very high deduction for people buying a second or more property which does not make sense.

Tax Sops and Financial Planning

While good financial planning takes maximum advantage of the tax benefits, it is not directed by tax benefits only. Good financial plans begin with the needs of the individual and once these can be fulfilled, the optimum tax benefit is taken. Often, however, people make mistakes which can be very costly.

For instance, most of the investment options under section 80 c require the investor to lock in the money 5 years. Schemes like NSC give returns of 8.5% but the interest is taxable. So even considering the initial tax savings, net returns are between 9% and 15% depending on the tax slab. Given that most personal loans and EMI schemes are at 14% to 16% interest rates, this is usually a losing proposition.

Of course, investment in PPF is way better because the interest income is also tax free. But since these are very illiquid (and early withdrawal is again taxed),  one needs to think carefully before investing in them.

Rules of thumb

If you are in the 10% tax bracket, then do not invest in tax saving schemes like traditional insurance and NSCs. If you are very certain that you will need money for 20-25 years, then invest in PPF.

If you are in the 30% tax bracket then you should completely meet the limit in section 80 c. Most of it will probably be covered by EPF and similar instruments. Also, you should not require to buy things (except house) on EMI.

If you are in the 20% tax bracket, then the difference between the two options are not significant. But if you do anticipate need for money in a couple of years, then it is better to not invest in locked up schemes.

Traditional Insurance

History

In the Indian context, traditional insurance refers to the popular plans by originally started by LIC that combined savings and insurance. These are typically sold by a freelancer agents who get a (pretty hefty - around 25%) commission for each plan they sell as well as a (small - 1-2%) commission each time the customer pays a renewal premium. Originally these were the only alternative to Post Office schemes (NSC and Kisan Vikas Patra) for a large number of Indians. This, together with the network of LIC agents is probably what accounts for their popularity.

Issues

I am highly suspicious of products that have a large commission because I find that the commissions are rarely justified for an informed investor. This is what makes me most skeptical of traditional insurance policies. At a minimum, these result in a lower yield for the investor.

The other major reason is that there is no good reason to club insurance and investment. Clubbing the two typically only results in opaqueness - it is not clear how much of the premium goes into insurance and how much into investment making it difficult to compare with other options. Often, this is used to mask the actual returns be-fooling the investor.

Analysis

A typical plan that was sold to me had an annual premium of 24,000. The insurance provided was Rs 5 Lakh. An online policy that would typically provide an insurance of 50 Lakh at an annual premium of around Rs 8,000. So we can assume that premium for Rs 5 Lakh would be Rs 800. This means that 23,200 goes into investment.

This plan gave 75,000 every 5 years and 5 Lakh on maturity. Other returns were unclear; there would be some bonus depending on the performance of the fund. I have seen a bonus of 8 Lakh at times for similar schemes. Thus the rate of return varies form 5-10%. It is here that opaqueness comes into play. We have no idea what the risk is; whether it is tied to markets (and which ones) so that the same can be hedged. We have no certainty regarding how much money we will get so it makes planning difficult.

The largest issue, however, is that these policies are VERY illiquid. Often if you stop paying the premium after 2-3 years, the policy lapses and you do not get any return. I know a large number of people who suddenly had increased financial commitments forcing them to stop paying premiums. Many of these people suffered losses to the tune of 50,000 to 1,00,000.

Alternatives

Fixed deposits would be very safe but would give a pre tax return of 8-9%. For people in the lower tax brackets, this would easily beat the traditional insurance policies. On the other hand, mutual fund investment over a 25 year period is likely to be as risky as the traditional insurance plans but would probably give 12-15% tax free.

Lastly, I would strongly recommend everyone to buy a term life plan to take care of the insurance needs.