Tax Savings – Check the diff between Pre and Post Tax Return

Tax Savings is a magical word in India. It is easy to sell a financial product with a tag of “Tax Savings”. Sometimes i fail to understand whether we invest to save tax or save tax by investing. I think it is former. It will not be an extrapolation to state that we are over obsessed to save tax. Here i am not suggesting that we should not save income tax. The pain point is when we select products for tax savings without financial calculations. In other words, most of the times we compromise on returns to save tax. Because of this reason, the traditional insurance plans like Money Back / Endowment plans are popular in India. The returns of these insurance plans are hardly 4% to 5%. The “tax savings” is a key reason for the popularity of these insurance plans.

In 30% income tax bracket, it might be beneficial for me to opt for product A with the tax free return of 8% rather product B with taxable returns of 11%. The product B’s pre-tax returns of 11% means post-tax return of 7.60% in highest tax slab. On the contrary, in 10% tax bracket the post-tax return of product B is 9.86%. Therefore, it is advisable to select Product B with taxable returns in 10% income tax bracket. As i keep highlighting that the biggest culprit is a comparison of Pre-Tax Returns with Post-Tax Returns. There is no standard rule or uniformity to report % returns. This anomaly is misused to mis-sell financial products. For accurate tax calculations, the comparison should be apple to apple. Moreover, you should consider effective tax rate 10.30%, 20.60% and 30.90% for calculations rather approximations.

Stages of Tax Savings

From a layman perspective, there can be two stages of tax savings i.e. tax exemption/deduction at the time of investment and secondly at maturity/withdrawal. Tax exemption u/s 80C is an example of tax savings at the time of investment. On the other hand, NIL long term capital gain tax in case of equity investments is an example of tax savings at maturity. Financially speaking there are three stages of an investment

(a) At the time of Investment

(b) Accumulation: Interest/Income/Dividend Earned from the Investment

(c) At the time of Maturity

In some cases, tax savings are available at all 3 stages i.e. Investment, Accumulation and Maturity/Withdrawal are exempted from income tax. Such financial products are referred as EEE (Exempt, Exempt, and Exempt). For example, PPF (Public Provident Fund) and EPF (Employee Provident Fund).

Investment under EET means investment and accumulation are exempted from Income Tax. The maturity proceeds  or withdrawals are taxed in the hands of the investor. My favorite example is National Pension Scheme. Some of the readers sought my opinion between PPF and NPS. The comparison is difficult as the returns of both NPS and PPF are not assured. I prefer PPF because of EEE status. An investor can prefer NPS for tax savings purpose provided the projected Post Tax Returns of NPS is comparable or more than PPF at the time of maturity. You can also consider the additional 50k exemption available under NPS at the time of investment. Therefore, it is difficult to choose between the two without financial calculations. At the macro level, PPF is preferred compared to NPS.

One of the most popular financial product in India is Fixed Deposits. As i will be sharing the example of Fixed Deposits later in the post therefore to clarify that FD is under ETE. The amount invested/principal is tax free both at the time of investment and maturity. Only the accrued interest is taxable. Just to clarify that investment under 5 years tax savings FD is exempted u/s 80C at the time of investment. For regular fixed deposit, the term exempt at the time of investment is used literally.

How to Calculate Post Tax Returns?

It might sound a rocket science but there is a simple formula to calculate the post-tax returns. It is as follows

Post Tax Returns = PoR (In %)

Pre Tax Returns = PrR (In %)

Effective Tax Rate/Tax Slab = TR (In %) i.e. 10.30%, 20.60% or 30.90%

PoR = PrR – (PrP x TR/100)

For tax savings purpose, it is advisable to compare post-tax returns of various financial products in consideration. Depending on the case to case base, it might be beneficial to pay tax and opt for higher returns compared to lower tax free returns. In other words, you need to check whether you are compromising on higher returns to save income tax.

There is NO universal thumb rule in this regard. For example, financial planners suggest debt mutual funds compared to bank fixed deposits. It is true in the majority of the cases but not always. An investor should keep 2 important factors in mind i.e. Effective tax rate/slab and investment horizon. The fixed deposit interest is taxable and there is a penalty for premature withdrawal. On the other hand, the returns of various types of debt mutual funds are dependent on the interest rate cycle. In case the holding period of debt mutual funds is less than 36 months, the short term capital gain is applicable. Therefore, it is difficult to conclude whether to invest in fixed deposits or debt mutual funds.

Income Tax is Good

As i shared earlier that an investor should consider net returns to make good investment decisions. In past, due to over obsession with tax savings, i missed some golden opportunities. To explain in simple terms, i will give you 2 options to select from

Option A: You pay me 100 Rs for 1 month. i promise to pay you a simple interest of 5%. Therefore, after 1 month i will pay back Rs 105 to you. In this case, i will not retain any incentive/tax and pass on the entire interest of Rs 5 to you.

Option B: In this scenario, i promise or there is a probability to generate returns of 9% i.e. Rs 9. But i will keep 3 Rs as my incentive or tax from 9 Rs. You will receive net 106 Rs after 1 month.

It is a no-brainer that option B is a better deal compared to option A. It’s a human psychology to perceive that option A with tax savings is better compared to option B. On the contrary, apple to apple comparison proved otherwise. Therefore, sometimes it is a wise decision not to run after tax savings and to pay Income Tax is Good for your financial health.

Words of Wisdom:

I have observed that investors in lower tax bracket can avoid financial products with longer lock-in period for tax savings purpose. If the income level is low then it is not advisable to lock the money for a longer period. The liquidity is important in such cases. Most of the suggestions available on the web are normally applicable for investors in the highest tax bracket. For example, in 10% tax bracket the post-tax returns of 8.5% FD is 7.62% compared to 5.87% in 30% tax bracket. In a lower tax bracket, fixed deposits returns are at par with the average returns of debt mutual funds. The investor need not wait for 36 months holding period to avoid capital gain tax.

On the contrary, in the highest tax bracket, the debt mutual funds makes more sense. The reason being, the fixed deposit interest will be taxed at 30.90% whereas short term capital gain tax is only 15% even if the holding period is less than 36 months.

To summarize, the investment decision is predominantly dependent on the tax slab of an investor. Any financial suggestion available on the web is generic in nature and does not consider all the tax slabs. As an investor, you should do your homework before making any financial investments.

Hope you liked the post.

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