January 29, 2012

Tax saving doesn't always pay back; sometimes it is better to pay tax

Tax saving is considered to be one of most important aspects of financial planning. With the financial year-end fast approaching, most investors would rush to fulfil their commitments so as to save as much tax as possible.

Consequently, many investors also end up making very bad investments as well. That is, there is duplication of instruments or unwanted investments and so on. So while saving taxes is a legitimate aspiration, overdoing it can actually do more damage to your finances than help.

There are several such instances where meaningless investments are made for the sake of saving taxes. For instance, take the case of medical insurance, there are many who are covered adequately through a group medical insurance of their companies.

But they still end up buying policies for themselves, family and parents, just to save taxes under Section 80D. The eligibility: Rs 15,000 annually for self and family, another Rs 15, 000 a year for parents which increases to Rs 20,000 if parents are senior citizens.  But the question to ask is whether you need them or all of them?

Most justify the expenditure by saying that the additional medical cover would actually be good for their finances and reduce financial pressure in case of any hospitalisation. Other reasons they cite are soaring medical costs, increased chances of falling ill and inadequate cover in a family floater. Of course, there is a dash of sentiment in their explanations - ‘My neighbour/ friend / colleague had to go through hell, there was no cover, they had to take a loan which they are still repaying and so on.’

But the numbers do not justify the expenditure. For saving just Rs 4,635 (even for the highest tax bracket), people end up buying cover for a premium of Rs 15,000. Then, there are those who invest in insurance policies to save taxes. Now, insurance is for security. But insurers and their agents sell it under the head of tax savings and investments. Many people, as a result, look at these products only from a tax saving perspective.

The security that an insurance policy provides is simply a footnote that many forget to read. When the tax season looms and the employer has delivered an ultimatum to show proof of tax saving investments, the scramble begins. Then, the helpful insurance agent utters the magic word - a policy that will help them save tax - Invest in an insurance policy, get the proof, submit it to their office - and life is bliss!
Investment Rs Tax
Savings Rs
15,000 4,635 If there is adequate insurance from
employer, don't invest in it
NSC/ 5 year
Time deposits
50,000 15,450 They are low-yielding instruments,
 post-tax returns are very low
Life Insurance/
50,000 It is a wasteful expense when
done without understanding
the policy
Home purchase
Couple of
lakh rupees
46,350 It puts undue pressure on finance
and the EMI for extended periods
is huge 
PPF/ VPF 50,000 15,450 It has to be used only when
the tenure matches one’s needs

The problem: Most are unaware of the policy they have invested in, whether that policy is suitable to them, whether the tenure invested is appropriate, what returns it could offer and whether it is a traditional or a unit-linked product and so on. In a nutshell, they have not evaluated the product for its merits and have just invested to save tax.

Another favourite among people is to buy a home to save tax. If it is the first home, the deduction available is just  Rs 1.5 lakh a year and tax savings would amount to Rs 46,350 in a year. For this reason, if one were to buy a home, it can put enormous pressure on one’s finances. Due to this, one’s lifestyle can become crimped. And it will continue to stay that way for years. It might have been much better just to have paid the taxes, invested the money after that, live life decently due to better cash flows ( in the absence of constricting loans ) and end up buying a property later,  when it is actually required. This kind of investment is very common and quite harmful.

First, they invest a big sum of money in a product that they may not need - that too, a product that may require them to service for a long time.

Second, once someone points out   pitfalls, they want to exit it in a hurry but many times the math forces them to hang around for years. For instance, if a policy has a lock-in for five years, there is little you can do. Yes, there would be some surrender value if you exit in the interim. But it will be most probably at a significant loss.

Third, even though they have been alerted, paying premiums at times becomes a habit. As a result, people forget to exit them at the right time.

Now, comes the most interesting part. Borrowing to save tax! Come December and the scramble to submit proof sets in. Those short of cash, resort to borrowing to save tax.  People are known to take personal loans or credit card loans to invest in tax saving instruments. If one were to calculate the costs and efforts vis-à-vis how much money is being saved, it may not make much sense to do it in the first place.
Any investment made, even if it made for tax savings, should make sense in the overall scheme of things. It needs to be a good investment.

We need to realise that if we actually calculate the total costs, it may be much costlier saving taxes than paying taxes, in many cases. Save taxes, where you can. Simply pay it, if it does not make sense. You would be much better-off.