The Income Tax Act, 1961 has various sections that allow for tax deductions and exemptions for certain kinds of investments made. Most of these tax-saving benefits in the act promote long-term savings and investments, thus helping taxpayers in building a well-balanced portfolio and a corpus for later years.
Tax savings on returns
When selecting the right tax saving scheme, apart from considering things like safety, liquidity, and returns, make sure you understand how the returns will be taxed. If the returns from your income tax saving schemes are not exempted, then the benefit derived out of your investment vehicles gets significantly reduced. Thus, the quantum of benefit derived becomes questionable. The interest amount in various tax-saving options is added to your income and therefore becomes taxable.
While choosing investment options for tax saving, when you are earning a salary or income from your business, the most advantageous investments are those that come with the status EEE (Exempt Exempt Exempt). EEE translates that income earned through these investments is exempted from tax at all three instances – investment, growth, and maturity – each subject to underlying terms and conditions.
Best tax saving options:
- Unit-Linked Insurance Plans
A Unit-Linked Insurance Plan (ULIP) combines insurance and investing into a single financial product. ULIPs, as opposed to pure insurance products, involve a level of risk since a portion of the premium is used to invest in securities that are subject to market risks. Only approved insurance companies show and advertise this product to clients. The product is extremely adaptable to the needs of the customer.
Unit Trust of India (UTI) introduced the concept of ULIP to Indian investors. Following the issuance of guidelines by the Government of India and the Insurance Regulatory and Development Authority of India (IRDAI), several firms combined their offerings to fit the consumers’ particular set of preferences.
A ULIP is a financial instrument provided by insurance companies that invests a portion of the premium in financial market products. Because it consists of both insurance and stock market investment, there have always been two schools of opinion as to who should regulate this product. In 2010, there was a tussle between the Securities and Exchange Board of India (SEBI) and IRDAI on the same issue. It was eventually decided that IRDAI would regulate ULIPs.
Section 80C of the Income Tax Act, 1961 allows you to deduct the premium you pay for a ULIP. Section 10(10D) of the act exempts the policy’s maturity returns from being taxed. This instrument provides you with dual tax benefits both during the investment period and after maturity.
With the new rules put forth in the union budget of 2021, if your annual premium goes above Rs. 2.5 lakh in a financial year, there will be no exemption under Sec10(10D) for the maturity benefits on the said ULIPs. This clause will only be applicable for new ULIP schemes taken on or after 1st February 2021.
- Equity-Linked Savings Scheme
Equity-Linked Savings Scheme (ELSS) is a type of mutual fund that is created with a diversified portfolio of equity market investments. The investment in ELSS mutual funds can be done through the Systematic Investment Plan (SIP) one-time investment route. These schemes generally come with a minimum lock-in period of three years.
ELSS investments come in two variants:
- Equity-Linked Savings schemes with dividend option
Under this option, the earnings of mutual funds are not reinvested, rather the same are distributed to the investor on predefined intervals as per the scheme particulars. These ELSS options do not guarantee payment of dividends, and it is entirely dependent upon the mutual funds’ performance.
- Equity-Linked Savings Schemes with growth option
Under this option, the earnings generated by a mutual fund are reinvested in the scheme. This scheme aligns with the investor who has taken the scheme with a long-term investment horizon. This enables them to reap the rewards of compounding as well.
Under both the options, the tax treatment is done differently. The dividend option gets taxed at the rate of 10% as Dividend Distribution Tax (TDT), before getting distributed to the investor. When it comes to the growth option, long-term capital gains get attached to returns, these are taxed at 10% if the return is above Rs. 1 lakh. Besides this, there is a Rs. 1.5 lakh deduction that can be claimed on investments in ELSS under sec 80C.
Advantages and disadvantages of these schemes
- Both the instruments provide both premium and maturity tax savings.
- ELSS has a minimum lock-in period of three years, the lowest among other tax-saving instruments.
- ULIPs provide life cover benefits in addition to an investment in equity and debt funds.
- Both schemes, if held for a longer investment horizon, can help in creating a corpus.
- Both the schemes are exposed to market risks.
- ELSS restricts liquidity with a minimum lock-in period.
- ULIPs provide maturity benefits only when the annual premium remains less than Rs. 2.5 lakh.
Both the options provide dual tax benefits. Though these schemes are categorised as risky investment options, if we broadly look at the historical performance, a longer term of investment in these instruments can be highly profitable. If maximum tax savings is your criteria, and you can take on a slightly risky investment vehicle to achieve a higher return, then these are the go-to instruments. It’s important to note that the tax benefits under section 80C are not available for those following the new tax regime. Hence, it’s recommended that you check with your financial advisor about the tax benefits you’ll be eligible for on these investments.