In your desire to save tax, don’t buy a flawed product.  Debashis Basu & Raj Pradhan explore the tax-saving traps best avoided and reveal a right approach to save tax

The period between January and March is the busiest one for life insurance companies. Lakhs of insurance agents aggressively sell unit-linked insurance plans (ULIPs) with a bait of tax saving. Insurance companies come out with new campaigns during this period.

ICICI Prudential Life has roped in Amitabh Bachchan with the campaign ‘Jeene Ka License’. Future Generali has introduced ‘Insurance Week’ with the campaign ‘Sign karo, Mukti pao’. The brand new campaign for IDBI Federal’s Wealthsurance Milestone Plan, says ‘Jisne Bhi Suna, Khareed Liya’, with the baseline ‘Nahin suna toh SMS kijiye...’ Over half of the policies sold in the fiscal year are sold during this period specifically due to their tax savings lure. Without the tax exemption, few people will buy ULIPs. During the tax-saving season, people are so desperate to save Rs30,900 in taxes by investing their hard-earned Rs1 lakh in certain kinds of savings, that even the most risk-averse person starts taking risks. Maybe the tax-saved money confers a sense of security. So, investors easily walk into various traps. One such trap is laid by unwary and even trustworthy bankers.

Last year, Ramesh Kumar (name changed) was looking to invest Rs1 lakh to save tax. The trusted bank manager told him that he was sending across a very close family friend to help him out. According to Mr Kumar, “The Reliance Life Insurance agent pitched very strongly for ULIPs. He told me that the Reliance Highest Net Asset Value (NAV) ULIP was the best, even though I informed him that I am 58 years of age—and a diabetic and heart patient—who is not looking at 10 years of returns. I was informed that I need to pay yearly premium only for three years and, after that, I could apply for withdrawal. I was told not to worry about anything. Trusting the bank manager and his family friend, I applied in good faith for the Rs1-lakh premium ULIP, as my knowledge was zilch in these matters.”

Mr Kumar opened the policy document, only to find a number of discrepancies. The policy term was for 10 years. His diabetes and heart condition were not mentioned. The charges for the first year were steep. “I called the agent and pointed out the many discrepancies. I was told that there was nothing to worry about—I just had to pay for three years and then partial withdrawals would be allowed,” he says. “I was told to be patient for three years. You will not be a loser. The health aspect would not affect you as the coverage was five times of Rs1 lakh, i.e., Rs5 lakh,” he added.


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The agent informed Mr Kumar that there were ‘problems’ only when the insurance cover was Rs10 lakh or more. But there were conditions for the highest NAV—like a wait-in period of 10 years. For a withdrawal in the 4th year, 20% would be deducted, in the 5th year, 10% would be deducted. The hapless Mr Kumar says that he was never made aware of these details. “I was only told that this investment was better than a bank fixed deposit, and it came along with tax advantages, too. I then went personally to Reliance Life’s Colaba (south Mumbai) branch office and met a senior person and told him my problem. I requested him to get me a refund by cancelling the policy, but he suggested he would try to convert it to a single-premium plan. I insisted on full refund and he said that he would try.” Now, Mr Kumar is stuck with this policy. “My request is pending. Don’t get conned into buying ULIPs from an insurance agent,” he says in his letter to Moneylife. This is one of the many we receive—but well after the tax savings season is over. Each complainant has a different story to recount—but each one has fallen for the tax-savings trap.

If ULIPs are tricky products, why do people fall for them? That’s because these are advertised heavily and there are millions of agents nudging you to sign on the dotted line. Remember, you have many other options for saving tax. Under Section 80C of the Income-Tax Act, a deduction of up to Rs1 lakh is allowed from taxable income in respect of investments made in specified schemes (see box above). So how should you go about deciding what are the right tax-savings products for you?

Various tax-savings products have diverse features and they appeal to different people, depending on their age and income structure. In general, mutual funds and term policies are considered better options compared to ULIPs. But as Yogin Sabnis, a financial planner and managing director, VSK Financial Consultancy Services, says, “There cannot be a thumb rule for tax planning. It depends on individual cases. Some people will benefit from Public Provident Fund (PPF), some from term plans (if they are not insured) and so on. The product has to suit individual requirements. Equity-linked savings schemes (ELSS) of mutual funds are a popular product. But if someone already invests in stocks, then ELSS may not be a good option. Debt products may be a better option to balance the portfolio.”

Taxpayers often go in for ULIPs, unknowingly. Those who know better go for ELSS. But just as we say don’t mix investments and insurance (like in ULIPs), don’t put retirement funds or long-term savings into risk products just because you are running out of time for the 31st March deadline. To understand the importance of this, let’s look at a product which is an obvious winner: ELSS. Long-term capital appreciation and dividends from ELSS are tax-free.

Though this seems like an attractive investment option, be careful before you bite the bait. If you sink your funds into ELSS at the wrong time, your returns could be low. Your money is locked in for three years, irrespective of the performance of the market. As an investor, your status will be reduced to that of a mute spectator, despite the market plummeting—or worse, shooting up.  You can neither withdraw money to cut losses nor to book profits. The variation in performance is huge. Some ELSS have done poorly. Indeed, it would be silly if you were to lose a part of your principal simply because you are sharply focused on saving taxes. Equity investments should be carefully planned, using a systematic investment plan (SIP) or, even better, by a system of value averaging and maintaining a long-term view of the investment, beyond the three-year lock-in period.

Old Is Gold

So, how should you plan your investments for tax savings? First, remember your tax-savings instruments have to fit into your overall financial profile and complement your other investments. Second, be clear about what you want that investment to do for you—this partly depends on your age. Third, decide for how long you can leave that money to work for you. Once you are able to answer these three questions, the task of zeroing in on the right investment products becomes easier. Here are some pointers based on your age, and point of your life cycle.

Up to Your 30s: This is the time to buy a term insurance cover and also take advantage of long-term compounding of returns. If you have already taken a home loan, then your preferred tax-saving options should be the tax deduction you get towards the repayment of the principal amount up to Rs1 lakh and also interest paid.  



From 30s to Mid-40s: According to Vivek Rege, a financial planner and managing director, VR Wealth Advisors, “For the married salaried employee with children, the Employees’ Provident Fund (EPF) contribution takes care of a part of the 80C tax concession amount.”

Then, you have your home loan principal repayment amount, insurance premium, and full-time student’s (who is your dependent) education fees. This should ensure that the Rs1 lakh limit is exhausted. If not, the balance that you have can be invested in PPF, ELSS and so on. “The self-employed have no EPF or Voluntary Provident Fund (VPF); they can explore PPF and ELSS.” Mr Rege adds, “Plan for your tax savings from the beginning of the (fiscal) year and not at the end. Debt investments will start accumulating interest, ELSS can also be invested in through a systematic investment plan (SIP). Moreover, plan your investments from a long-term point of view.”

Late 40s to 60: If you are in your late 40s and you are looking for stable and secure investments from the retirement point of view, you ought to consider ELSS, PPF, VPF, National Savings Certificates (NSCs), Senior Citizens Savings Scheme (SCSS) or five-year tax-saving fixed deposits with banks.
The investment in EPF is mandatory for salaried employees working for a company having 20 or more employees. PPF is available for anyone. If an investor at that age is not interested in ULIPs or ELSS, and so Rs1 lakh as a tax-saving investment can be divided among term insurance premium paid in the year, contributions to EPF/VPF/PPF and tax-saving fixed deposits. An investment in an EPF/VPF will give higher (9.5%) rate than PPF (8%) and, hence, is a great option at this time. Tax-saving fixed deposits can fetch you 9.25% (IDBI Bank) which is better than the interest rate from SCSS (9%).

But, remember, many of the above-mentioned investments have a lock–in period. PPF is locked in completely for seven years—after which you can withdraw 50%. You can subsequently make one withdrawal a year and the rest of the scheme runs for 15 years.

However, the advantage of PPF is that along with tax savings on investment of Rs70,000 a year, the interest on PPF is also tax-free. It is, indeed, a boon for risk-averse customers who don’t need to access their funds for 7-15 years.

NSC is a good option for a shorter duration; the lock-in period is only six years. The interest is also compounded semi-annually and, hence, is more than that on PPF. Even though the interest is not tax-free, it is allowed to be part of the 80C deduction amount. A unique advantage of PPF is that it cannot be attached by the tax authorities or a court of law. So this is an attractive tax-saving tool for entrepreneurs in fluctuating and highly leveraged businesses.

Currently, SCSS offers a higher interest rate than PPF and NSC. Interest on tax-saving fixed deposits varies from bank to bank and also with market rate fluctuations. Interest on SCSS and tax-saving fixed deposit interest is neither tax-free nor allowed to be part of your 80C deduction.

EPF and VPF—Two Good Bets

Equity is still the best option for long-term asset growth. But for salaried employees, two of the best options are EPF and VPF. These two options are real savings products unlike the surreal savings options offered by insurance companies. The money you want to protect for retirement can grow on a compounded basis over the years. Employees are made to contribute 12% of their basic salary; employers contribute an equal amount. You can also put in an additional contribution of up to 100% of your basic salary plus dearness allowance towards VPF. Your employer’s contribution will be limited to the mandatory amount; this will not match your voluntary contribution. VPF is directly linked to your EPF account. If you have not already started investing in VPF, it may be too late for the deadline of filing your returns for this year (31 March 2011). You can certainly start the process by talking to your employer so that it benefits your next year’s tax savings.

Mr Rege says, “The interest rate for EPF/VPF was increased from 8.5% to 9.5% due to the surplus generated over the years because of accounting issues. It had to be distributed to the people. The rates may not remain at 9.5% for the next year. But it is still a good option.” However, do note that you should be prepared to have your money locked in till the time of your retirement. The money can also be withdrawn two months after you quit your current job, or it can be transferred to a new EPF account created with your new employer. In case you make a premature withdrawal, you will have to pay tax. If you have paid off all your debts—such as your housing or car loan—and are prepared for a longer lock-in period, it is a good conservative strategy (especially if you are close to retirement). The best part is that the interest that you will earn on it over all these years is also tax-free!

Infrastructure Bonds–80CCF

You can bring your taxable income down by up to Rs20,000 if you invest in long-term infrastructure bonds, as announced in last year’s Budget (2010-11). This amount is over and above the Rs1 lakh limit under Section 80C. These carry a lock-in period of five years (maturity at 10 years from the deemed date of allotment) with a buyback option after five years. IDFC, one of the issuers of such bonds, was claiming a tax-adjusted yield of up to 17.85% for investors, but this is simply not true. Just understand that the yield on maturity is 8% compounded annually. The interest earned on these bonds is taxable. Putting money in infrastructure bonds is not a great option, if you have already invested a lot of money in debt instruments. What you will gain by way of saving on taxes, you will lose on the returns.

Mediclaim Premium Deductible under 80D

You can claim deductions of up to Rs15,000 in case you have taken a medical insurance plan for yourself, your spouse, dependent parents or children. You get an additional Rs15,000 for your parents’ medical insurance under Section 80D for premiums paid. This limit has been enhanced to Rs20,000 for senior citizens. A regular health insurance policy does not help exhaust the Rs15,000 deduction limit or Rs20,000 for senior citizens that Section 80D of the Income-Tax Act permits. To take advantage of the unutilised tax breaks, a few health insurers—like Apollo Munich, ICICI Lombard and Max Bupa—have come up with plans that have higher premiums, extend cover for outpatient department (OPD) treatment and, in some cases, maternity expenses too. Unlike standard mediclaim policies, medical expenses that do not necessitate a 24-hour hospitalisation period, such as dental treatment, pregnancy-related expenses, diagnostic tests and pharmacy bills are covered, too.

According to Mahavir Chopra, head, e-business, Medimanage, a health insurance broking company, “Products which provide OPD coverage are not cost-effective. Until India has healthcare provider chains with a well-spread network that provides real value to customers, the OPD benefit does not have any meaning. These products are five times more expensive than the standard product and they are mostly sold as a workaround tool for saving tax.” Mr Rege adds, “For 80D tax savings, mediclaim premium (payment) is a good option. Even if the employer offers a group policy, it is better to go for individual policy (not a floater) from a long-term perspective.”

Ultimately, dealing with income-tax deductions is the same as dealing with various financial products. You need to understand what each of them delivers and choose what suits you the best. And avoid the ad pitch. A young couple paying off a large home loan will have no money left to invest in ELSS or ULIPs. A Central government employee, staying in government-provided housing, is sinking in a lot of money into a PF and is already heavily invested in debt. He must look at tax-savings via long-term exposure to equity which can be delivered by ELSS.  Don’t get swayed by what is offered through high-pressure advertising or what your friend, agent or cousin tells you. Even if they have your best interests at heart, they may lead you inadvertently into tax-savings traps.

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