Investing because you want to save tax is possibly not the best of ways to start. Nevertheless, it has become a starting point for many salary earners. Close to the year end is when you begin to top your PPF account or buy an insurance or a tax saving mutual fund scheme. However, letting tax lead your investment decision is an effective way to plan your long-term financial journey.
Similarly, you may think that taking on a housing loan is good tax planning given the interest and principal deduction that is allowed, but if you don’t need to buy the house why take on the loan?
In the long run, net returns matter
Net returns, or returns after adjusting for tax paid is something that gets overlooked very easily. It is incorrect to consider your tax saving as an absolute figure and then consider your investment return separately.
For example, many people have opened PPF accounts as a first preference for a tax saving investment. Both PPF and equity mutual funds are long term investments. PPF has a 15-year lock-in, and equity mutual funds have no formal lock-in but require you to remain invested for at least 5-10 years (if you want your investments to deliver the best results).
The current return for PPF is 8% per annum, equity invested for 15 years has an expected return of 12% per annum. However, PPF return is tax free whereas equity mutual funds capital gain is taxed at 10% (long term). Nonetheless, with an expected return of 12% pa, the post-tax return in equity mutual funds is about 10.8% per annum. Not only are expected returns higher, equity mutual funds are a more flexible option given that you can redeem at any time you like.
Similarly, you may think that taking on a housing loan is good tax planning, given the interest and principal deduction that is allowed, but if you don’t need to buy the house why take on the loan?
Choose your investments based on your goals
Needless to say, that you should not ignore tax planning. Align tax planning such that your financial goals are also achieved. As shown above, an equity mutual fund is a better choice than PPF if you have many long-term financial objectives.
Long term financial goals are best served by growth assets like equity which create wealth if you remain invested for long periods and short-term goals are best served by stable return products which are flexible and low risk.
While, you don’t want to invest in a product where your post tax returns are too low, never let the absolute tax benefit override the return advantage of a product. First define why (goal) you need to invest, then pick the investment product that suits your needs best and then consider its tax benefit.