Tax-saving investments come in various shapes and sizes. Think of them as pieces of a jigsaw puzzle. Every piece is as important as the other and even if one piece is amiss, the puzzle will be left incomplete. On a similar vein, every tax-saving investment is important and serves a definite purpose. Put together with each other, tax-saving investments can form an excellent portfolio to help you not only save taxes but also achieve financial goals.
Broadly, tax-saving investments can be categorized as equity-oriented and debt-oriented. The National Pension System (NPS) is the only tax-saving investment that invests in both equity and debt. But otherwise, popular tax-saving investments have a portfolio of either equity or debt.
Equity linked Savings Scheme (ELSS) are tax-saving mutual funds that invest in equities. On the other side, Public Provident Fund (PPF) and Tax-saving Fixed Deposits (FD) invest in debt. These investments earn the investor a tax break of up to Rs 1.5 lakh under Section 80C of the Income Tax Act. These three investments–ELSS funds, PPF and FDs–can be clubbed together to build a well-diversified and effective portfolio of tax-saving investments.
For the time being, the NPS isn’t tax-efficient enough upon maturity to qualify as a worthy 80C investment. However, there is an additional Rs 50,000 that can be invested in the NPS, over and above the Section 80C limit, to avail further tax benefits under Section 80CCD(1B). This tax break can be availed by you if you need to save taxes more than the Rs 1.5 lakh allowed under 80C, but the 80C investments should be limited to ELSS funds, PPF and FDs for now.
To figure out how to spread your tax-saving investments across these three options, you need to first figure out how much risk you can assume. As ELSS funds invest primarily in the stock markets, they come with equity-related risks. However, they are worth the risk because only equity has the potential to earn inflation-beating returns over the long-term. And this risk can be curbed by diversifying your tax-saving portfolio by investing in PPF and FDs as well. This sort of a portfolio mix allows equity to generate returns and debt to provide stability.
How much you should invest in which of the investments will depend on your risk profile. Traditionally, risk profile can be judged by your age. On a general basis, young investors can take higher risks. As you near retirement, your potential to take risks keeps coming down because you would need a corpus in your twilight years to rely on.
With time on hand, equity can lead to high returns over periods of 10 years and more. ELSS funds also earn compounding interest, which allows you to earn interest on not only your principal but also the interest. This is why young investors should have at least 70% of their tax-saving portfolios in ELSS funds.
For those who are nearing retirement, PPF and FDs should be the major part of their portfolio because stability and guaranteed returns would be their priority. That said, they shouldn’t completely ignore ELSS funds because fixed income eats into your principal as it can’t beat inflation. Some amount of exposure to ELSS funds is important for everyone.
This is how a mix of different tax-saving investments can help you create a diversified portfolio that will serve the dual purpose of saving taxes and building wealth.
This article was first published on Deccan Herald on 13 June 2016.