Avoid 6 common tax planning mistakes

Tax planning is an important financial objective any person has. Tax planning starts when a person starts working and continues almost throughout one’s life, even after retirement. We have observed that, people often fail to look at tax planning objectively and start making investments related to tax saving in a very mechanical way. Tax planning is an integral part of our financial planning process and thoughtful planning goes a long way in helping us achieve our financial goals. In this blog post, we will discuss 6 common mistakes that you should take care to avoid in your tax planning.

1. Starting tax planning too late in the year:

   Many investors postpone tax planning till the last quarter of the year. Many investors do not begin their tax planning till their employers ask them to submit Section 80C and other investment proofs for TDS purposes. The last minute rush to make tax saving investments before their employer’s deadlines does not allow sufficient thought being given to these investments and linking them to the financial goals of the investor. Many a times, investors make sub-optimal tax saving investment decisions which they regret later.
   
   Most salaried investors know the fixed component of their salary at the beginning of the financial year. You also know how much interest you will get from your existing bank fixed deposits. You can make some assumptions about your incentive and bonus for the year. This is a very good starting point and you can start your tax planning in April itself. This will allow you sufficient time to plan your investments carefully and make the right investment decisions.
   
   Did you know about mutual fund taxation in the financial year 2019-20



2. Making tax saving investments in the last quarter:

   When you make your tax saving investments in the last quarter, you lose the interest/ returns you could have earned in the first 9 – 10 months of the year if you began early. On an investment of Rs 1 – 1.5 lakhs, this can be a substantial opportunity. Assuming 10% p.a. return on investment, 10 months of returns on Rs 1 lakh investment is Rs 8,333. Over 20 – 25 years, you can lose Rs 5 – 8 lakhs just because you waited till the last quarter, to make your tax savings investments.
   
   Though some investors allocate a portion of their annual bonus received in February or March to tax savings investments for the following year, many investors may not have sufficient investible funds to make all their tax savings investments at the beginning of the year. If you invest in mutual fund equity linked savings schemes (ELSS) through monthly systematic investment plans (SIP) from your regular savings, you will get returns on all your monthly investments and benefit in the long term from the power of compounding.
   
   Suggested reading – How rollover in tax saver mutual funds provide substantial benefits



3. Not linking tax planning with financial goals:

   We had touched upon this point earlier. Most investors make tax planning investments in a mechanical way, just to save taxes. Tax planning is not purely about tax savings. It should be linked to your financial goals. You should invest in schemes which not only gives you tax savings but also helps you meet your financial goals. Different 80C investment schemes have different risk/ return profiles. You should invest according to financial goals and risk appetite.
   
   

   Source: Post Office, LIC life insurance endowment policy historical IRR, Bankbazaar, Advisorkhoj

   
   All tax saving investments are long term investments (e.g. PPF: 14 years, NSC: 5 years, Tax Saver FDs: 5 years, life insurance endowment plans: 15 – 25 years, ELSS: minimum 3 years). Historical data shows that equity is the best performing asset class in the long term. For investors with moderately high to high risk appetites, mutual fund ELSS has the highest wealth creation potential among all Section 80C investments and therefore is best suited for long term financial goals.
   
   Suggested reading – what are equity linked saving schemes and their benefits



4. Ignoring liquidity implications:

   Investing for tax saving should not necessarily imply locking up your money for many years. Though we always recommend long term investing for maximum wealth creation, you should also think about liquidity profile of the asset should you urgently need money for some purpose for some unforeseen reason. That is why you should be very thoughtful about tax planning and make well considered investment decisions. The table below shows the liquidity profile of different 80C tax savings investments. You should factor liquidity as a consideration when making investment decisions.
   
   




5. Mixing tax planning and life insurance needs:

   This a very common mistake, even though there is much more awareness. Life insurance is one of the most important financial needs of any family. Lack of adequate life insurance cover can put your family at considerable financial risk in the event of an unfortunate death. As such, life insurance needs to be a separate priority and not mixed with tax savings or investments. You should assess how much life cover you need and buy sufficient insurance before making other investment decisions.
   
   Life insurance premiums qualify for tax savings under section 80C. If you let tax saving priorities guide your life insurance decisions you may end up buying the wrong insurance product and also invest sub-optimally (very low returns). Let us explain with the help of an example. You can buy Rs 1 crore of 20-year term life insurance cover (sum assured) for Rs 10,000 – 14,000 annual premiums (source: Policy Bazaar) assuming your age is around 35 years. There are no survival benefits (ROI) in a term plan. On the other hand, in an endowment plan, you may have to pay around Rs 50,000 in annual premium over 20-year policy term for Rs 10 lakh sum assured (source: PolicyBazaar). On maturity of the policy, you will get the sum assured plus bonus; historical return on investment (IRR) is in the range 5 – 6%. Purely from a combined tax savings and investment perspective, the latter plan (endowment) may seem more attractive to many investors. But it will be a wrong decision both from life insurance and investment perspectives, if you separate the two priorities. You will be severely under-insured compared to term life insurance cover. At the same time, from an investment perspective your returns will be sub-optimal compared to most 80C investment options.



6. Ignoring tax implications of tax planning investments:

   Tax planning should not just be about tax savings. You should also consider the tax consequences on the maturity amounts when doing your tax planning. Taxes can take a big part of the returns and you should ensure that you invest in tax efficient schemes to ensure best returns for your financial goals.
   
   

Tax implications in Budget 2020

On February 1, Finance Minister presented the 2020 Union Budget in the Parliament. Our team will go through the fine-print and analyze the tax implications for different scenarios over the next few days. We will have a separate article exclusively on Budget 2020 and tax implications for investors later this month. However, for the benefit of investors who may have immediate questions / concerns regarding the Budget, we will touch upon a couple of points which impacts investors.

The Government has introduced a new income tax regime which has 7 income tax slabs as opposed to 4 slabs in the current regime. There is no change in income tax and exemptions for incomes up to Rs 5 lakh. For incomes between Rs 5 lakh and Rs 15 lakh, the Government has offered lower tax rates (please see table below). However, if you opt for the new tax regime, then you will have to forgo most of the exemptions (including Section 80C)that you were claiming under the current tax regime.

The Government has removed 70 income tax exemptions in the new tax regime. They include Standard Deduction, Section 80C, HRA, LTA, home loan interest (Section 24), medical insurance premium (Section 80D), savings bank interest, education loan interest (Section 80E). If you opt for the new tax regime, you will not be able to claim these exemptions. Each investor will have to do his / her own tax calculations for the new tax regime and compare it with the old tax regime (including the exemptions mentioned above) and decide which is better for them. It is important for investors to understand that the new tax regime is optional. If you think that the old tax regime works better for you, you can stick to the old one.

The second important change which will affect investors is change in dividend taxation. The Government has abolished Dividend Distribution Tax (DDT), which companies are liable for before paying dividends to shareholders. The change in dividend taxation, removal of DDT, also applies to mutual fund schemes which pay dividends to investors. The effect of this change is that investors will get more dividends. However up until this now (and this financial year), dividends were tax free in the hands of the investors. From the next financial year onwards, dividends will be added to your income and taxed as per your income tax slab.

Currently, the DDT for equity oriented funds is 10%. So if your income tax slab rate is less than 10%, then this change will be beneficial for you. For income in higher tax brackets, this change will result in more taxes. The DDT for non equity funds (debt funds) is 29.12%. The change in dividend taxation will be beneficial for all investors whose income tax slab is less than 30%. However, for investors in the 30% tax bracket, this change will result in more tax outgo.

The final point that we want to mention about Budget 2020 in this article is about long term capital gains taxation. Long term capital gains tax will remain in place at existing rates – 10% for equity funds and 20% after indexation for debt funds.

Summary

In this blog post, we discussed some common tax planning mistakes which many investors make. Tax planning is not rocket science. In our view, tax planning is a simple 4 step process:-

• Estimate how much you need to invest - factoring in mandatory investments like Employee Provident Fund (EPF), regular investments like premiums of your ongoing life insurance policies and expenses like home loan principal payments, etc.


• Evaluate various investment options and link them with your medium term and long term financial goals.


• Select the best investment based on different considerations discussed in this post like financial goals, risk appetite, liquidity and tax consequences.


• Form a disciplined plan for your tax planning investments and stick to it, e.g. investing through monthly SIPs.

We hope that you have already made your tax planning investments for this financial year. If not, then we urge you to treat tax planning as an important financial priority and make thoughtful investment decisions considering the various factors we discussed in this post. You should always consult with your financial advisor, if you are in doubt about the right investment for your specific financial needs.