Strike a balance

It’s that time of the year again: the financial year is drawing to a close while you are yet to chalk out an investment plan to save tax. There are many who choose to make tax-saving investments towards the end of the financial year. This is why life insurance companies get 40 per cent of their total annual business in the January-March quarter, while there’s a mad rush among mutual funds to launch products under the equity-linked savings scheme (ELSS). Given the bear run on the bourses since January last year, the investment scenario is different this time. What every investor is worried about now is the ‘return of capital’ and not the ‘return on capital’. Hence, unlike the last few years, people are wary of taking risks and would rather prefer to play it safe. The right mix So, how can one assure capital protection along with a decent return? There are instruments such as NSC, PPF and tax-saving fixed deposits (for a minimum of five years) with scheduled commercial banks or post offices that give assured returns as well as tax relief under Section 80C. However, the interest earned on all these instruments, except for PPF, is taxable. Banks will deduct tax at source (TDS) on the interest income at the rate of 10 per cent. Depending on the tax bracket, any additional tax liability will have to be paid by the depositors themselves. TDS is not applicable to NSC or a five-year post office fixed deposit. The onus of paying tax on the interest income is entirely on the depositor. Also, each instrument offers different rates of interest. Moreover, the calculation of interest is different for different schemes (see table 1). So, while all these instruments offer assured returns and same tax benefits under Section 80C, the effective return differs significantly from one another — PPF is the best followed by bank fixed deposits. But a PPF has a lock-in period of 15 years compared with five years in tax-saving bank fixed deposits and one cannot invest more than Rs 70,000 a year in a PPF account. Balancing act However, there is another way in which one can assure capital protection and yet look for a higher return. This involves a simple strategy of splitting one’s investment corpus between bank fixed deposits and equity-linked savings schemes of mutual funds. While the fixed deposit assures capital protection, ELSS promises a higher return as well as lower tax liability on the overall portfolio — investments in equities are tax-free after one year. Let us explain this. The maximum deduction one can claim under Section 80C is Rs 1 lakh. If you plan to invest Rs 1 lakh, split it between a bank deposit and ELSS. You choose a tax-saving deposit with a scheduled commercial bank that offers the highest interest rate (see table 2). After the latest round of reduction in deposit rates, some public sector banks are still offering an interest rate of 8.5 per cent on their tax-saving fixed deposits. At an interest rate of 8.5 per cent compounded quarterly, you need to deposit Rs 66,000 for a period of five years to get a maturity amount of approximately Rs 1 lakh. While you are left with Rs 34,000 more to invest, the bank deposit ensures protection of your entire investment of Rs 1 lakh. However, you will have to pay an income tax on the interest income of Rs 34,000 (maturity amount of Rs 1,00000 — the original investment of Rs 66,000). Assuming that you are in the highest tax bracket (30 per cent), your income tax liability on the accrued interest will be Rs 10,200 (30 per cent of Rs 34,000). Your interest income after tax will be Rs 23,800 (Rs 34,000 — Rs 10,200). After five years, your maturity amount after tax will be Rs 89,800 (Rs 66,000 principal+Rs 23,800 interest). Equity link The next step would be to find an ELSS that has a good performance record over a period of five years and invest the remaining Rs 34,000 in that scheme. In the past five years, tax planning schemes of mutual funds have given an average annualised return of 11.39 per cent — the best fund gave a return of 24.71 per cent and the worst fund generated 0.94 per cent. These returns take into consideration the recent mayhem in the equity markets. It is to be noted that none of the tax-planning schemes that are around for five years gave a negative return. Even the minimum annualised return generated by diversified equity schemes over the last five years was zero — that is, neither gain nor loss on the original investment. Thus, the probability of a capital loss on an investment in an ELSS is almost zero if you invest the money for five years or more. Let us consider three situations. n You get a 10 per cent annualised return on your ELSS investment. In this case, your investment of Rs 34,000 will grow to Rs 54,757.34 (compounded return) in five years. Taking into account the investment in a bank fixed deposit, your initial capital investment of Rs 1 lakh grows to Rs 1,44,557 net of tax (Rs 89,800+Rs 54,757). The effective return on investment thus works out to over 7 per cent. n Your ELSS investment doesn’t grow. In this case, your investment at the end of five years will be Rs 1,23,800 net of tax (Rs 89,800+Rs 34,000) and the rate of return will be over 4 per cent. n Your ELSS investment suffers a capital loss of 20 per cent, which is Rs 6,800 (20% of Rs 34,000). Post loss, the amount will come down to Rs 27,200. At the end of five years, your investment will stand at Rs 1,17000 (Rs 89,800+Rs 27,200) — a 3 per cent rate of return. The way many stocks have been battered on the bourses may prompt most to stay away from equities. But, remember, equity as an asset class generates the highest return. The markets are sure to make a U-turn. Hence, plan a judicious mix of fixed deposits and equities to save the maximum and reap the highest return.