Section 80C, tax planning and investments

[K.Karthik Raja]

Section 80C, tax planning and investments

Learning how to plan your taxes is a major part of choosing an
investment strategy. In this article we will look at Section 80C, one
of the most important provisions for investors in the tax laws.
What is Section 80C?

The government, in order to encourage savings, gives tax breaks to
certain financial products as discussed in Section 80C of the Income
Tax Act. These investments are often referred to as 80C investments.

Up to a limit of Rs 1 lakh, the money that you invest in these
products is deductible which means that you don't have to pay income
tax on it. Thus if you are in the 30 per cent tax bracket and you
invest the maximum allowed you save Rs 30,000 in taxes.

There are a wide range of investments you can make to claim the
Section 80C benefit. To keep things simple we will focus on two
categories: Small savings schemes and ELSS (equity linked savings
schemes). Other 80C products include your provident fund, the
repayment of principal on your home loan and your life insurance
premium.

Small savings schemes

These include the public provident fund (PPF) and National Savings
Certificate (NSC). They offer a return of around 8 to 8.5 per cent
which is quite low compared to typical returns in equity products.
Furthermore, there is a relatively long lock-in period, 15 years for
the PPF and 6 years for the NSC. Their main advantage is that they
offer a guaranteed return unlike equity-based products.

Equity linked savings schemes

These are basically mutual funds which are specially created to
provide tax benefits. As with regular mutual funds there is no
guaranteed return and you can lose money in a period of falling stock
prices as has happened in the first half of 2008. However, ELSS
usually provides a higher return than small savings schemes and also a
lower lock-in period of three years.

Examples of ELSS include Franklin India Taxshield and HDFC [Get Quote]
Taxsaver. As with regular mutual funds, these schemes pursue a range
of investment strategies: For instance, some may focus on large cap
stocks while others may focus on small and mid cap stocks. It makes
sense to invest in more than one scheme to diversify some of your
risk.

Making a choice

How do you decide to allocate your Rs 1 lakh 80C limit? This will
depend on your other financial decisions; for example whether you have
taken a home loan or purchased life insurance. As to the decision
between small savings schemes and ELSS two of the most important
factors are your attitude to risk and inflation.

As recent months have shown so clearly, stock markets are a lot
riskier than small savings schemes. However, the flip side is that
riskier investments like stocks offer a higher rate of return
particularly over the long run. From the perspective of a young
investor who may not need most of her/his investment money till
retirement it probably makes sense to tilt towards riskier assets.

The other important consideration when evaluating returns is to adjust
for inflation.

In other words, if your investment generates a return of 8 per cent
and inflation is 7 per cent, then your inflation-adjusted return is
only one per cent. When inflation moves into double digits you are
actually making a negative inflation-adjusted return, as is happening
currently. This is a fundamental problem with any investment product
that offers a fixed return at a time of high and rising inflation.

By contrast stocks are a better hedge against inflation especially in
the long run. Though inflation increases the costs of firms it also
allows them to charge a higher price to their customers thereby
protecting profits to some extent. This in turn means that stock
prices and equity-based products can offer better protection from
inflation over a number of years though not necessarily in the short
run.

What about the element of timing when it comes to equity schemes? For
instance, stocks have clearly taken a pounding in the last six months.
However this doesn't necessarily mean it's a bad time to invest in
stocks; valuations in some companies look quite attractive now and
over a three-year horizon you could see decent returns.

From the point of view of the average investor it's probably best to
take timing out of the picture by following a systematic investment
plan which means you invest a fixed amount every month.

Small savings schemes and ELSS each have their advantages and
disadvantages. Based on your investment strategy and particularly your
attitude towards risk you have to choose how much to invest in them as
part of your Section 80C investments.