As an investor you now have a plethora of investment options available, ranging from mutual funds, equities to fixed income securities like bank fixed deposits, bonds etc., Each and every investment you make has to go through three different stages i.e., i) Investment / Contribution stage, ii) Income Earning Stage & iii)Withdrawal or redemption stage.
Generally most of the investors tend to make investments based on the tax treatment or the tax benefits available at the investment stage only. However, we need to be aware of the taxation rules applicable in all the three stages.
For example: Let’s say you would like to book a 5 year Tax saving Bank Fixed Deposit. The investment in FD is eligible for tax deduction under section 80c. This is in the investment phase. Your capital earns ‘interest income’ for the next 5 years. This is taxable. When you redeem the FD on maturity, the withdrawal is tax-free given that tax is paid at the ‘growth or income earning stage’ itself.
If you are aware of the tax implications at various investment stages, you can pick tax-efficient investment options. Tax efficiency is a measure of how much of an investment’s return is left over after taxes are paid. Tax efficiency is essential in order to maximize net returns on our investments. You need to consider the net tax adjusted returns and not just gross returns from your investments.
However, the tax benefits should not be the main criteria for short-listing an investment option. They should be incidental and not the core.
For example : You need to buy a Term insurance plan if you need adequate life cover, not because you get Tax exemption under section 80C.
Investment Stages & Tax Treatment
As discussed above, an investment goes through three different stages;
- Investment (or) Contribution stage
- Earnings (or) Growth (or) Accumulation stage &
- Withdrawal (or) Redemption (or) Maturity stage
And in each stage the investments/earnings can either be Taxed (T) or Exempted (E) from the taxes. So, we can have 6 possible combinations of Es & Ts for three different stages as below;
- EEE : Exempt –> Exempt –> Exempt (meaning you can avail tax deductions at the time of investment, the income earned on this investment is tax exempted & even the maturity amount is tax-free)
- EET : Exempt –> Exempt –> Tax
- ETE : Exempt –> Tax -> Exempt
- TEE : Tax –> Exempt – > Exempt
- TET : Tax –> Exempt -> Tax
- TTE : Tax –> Tax -> Exempt
How are your investments taxed?
Let’s now pick various investment options and arrange them as per the above taxation regimes.
(NPS withdrawals will fall under EEE category w.e.f April, 2019)
- EEE : Under this regime, taxes are not applicable in all the three investment stages. You get tax deduction at the time of investment, the income earned on the capital is tax-free and the withdrawal is also tax free. EEE can be the most preferred choice while short listing your investment options. Some of the investment avenues which have EEE model are;
- Employees Provident Fund.
- Latest clarification on Interest earned on EPF : If an employee who is a member of EPF scheme, quits or retires from his employment and continues holding the accumulated PF balance, he/she has to pay tax on interest from the date of unemployment. So, the interest on EPF is tax-exempt only when the member is employed and the Interest credited to an employee provident fund (EPF) account after an individual ceases to be in employment is taxable in his/her hands in the year of credit. Interest that has been accrued post employment is taxable. This is as per the recent order by Income tax appellate Tribunal. (Updated on : 20-Nov-2017)
- Public Provident Fund
- Sukanya Samriddhi Scheme
- Life Insurance Policies (if your objective is to get adequate life cover, opt for Term insurance only. Other traditional plans like money-back/endowment can give you very low returns)
- Retirement Plans offered by Mutual Fund houses
- ULIPs (Unit Linked Insurance Plans)
- NPS becomes an EEE investment w.e.f 1st April, 2019 (Latest Update : Dec 2018).
- Employees Provident Fund.
- EET : The tax treatment under this model is, you can claim tax deduction at the time of investment and the earnings is tax-free, but withdrawals at the time of maturity are taxed. So,under EET, the taxation is deferred till the time of withdrawal. Most of the pension plans fall under this category.
- Unit Linked Pension Plans
- ELSS Tax Saving Mutual Funds (The LTCG on shares & Equity funds is taxable @ 10% from FY 2018-19)
- Annuity based Pension plans
- NPS (National Pension System) (Latest update Budget 2016 : The 40% of the corpus that an investor can withdraw on maturity is proposed to be made tax free. The remaining 60% of the NPS corpus has to be used to buy an annuity product. Note that monthly pension (annuity income) is fully taxable.)
- ETE : Under this arrangement, tax benefits are available at the time of investment but earnings are taxed. The withdrawal at the time of maturity is tax-exempt given that taxes are paid at the growth/earnings stage itself.
- 5 Year Tax Saving Fixed Deposits
- NSCs (National Saving Certificates)
- Sr.CSS (Senior Citizen Saving Scheme)
- TEE : At the time of investment no tax benefits are available and you invest your tax adjusted income. However the earnings and withdrawal can be tax-free.
- Tax Free Bonds (Interest income is tax-free and bonds if held till maturity, no taxes are applicable)
- TET : Under this model, earnings during the growth stage are tax exempted.
- Debt oriented Hybrid Mutual Funds
- Equity oriented Mutual Funds (The LTCG on shares & Equity funds is taxable @ 10% from FY 2018-19)
- Balanced or Hybrid Equity funds (No tax on capital gains on stocks/equity funds if held of more than a year)
- Debt Mutual Funds
- Monthly Income Plans of MFs
- Fixed Maturity Plans of MFs (FMPs)
- Debentures (Interest earned through NCDs, if held until maturity, is clubbed with your income and taxed at your marginal income tax rate)
- TTE : This is possibly the lest tax-efficient model of all. There is no tax deduction offered at the time of investment and earnings are fully taxable. With income taxed every year, there are no tax implications at maturity. Unfortunately, a major portion of Indian Households’ savings are invested in the financial products which fall under this category. These investment options are not only less tax-efficient but can also erode your wealth if invested for long-term.
- Fixed Deposits
- Recurring Deposits (RDs)
- Post office Monthly Income Scheme
- Tax Saving Bonds
You should invest in financial products based on your financial goals. If an investment option meets your requirements and is also a tax efficient one then it is well and good. Your investment strategy is to max out your after-tax returns.
But, do not invest in a financial product just to save some TAXES. The cost of buying wrong financial products may outweigh the cost of taxes. Tax Planning is not a goal but a tool. Remember “Tax Planning aloneis not Financial Planning.”
(Image courtesy of Stuart Miles at FreeDigitalPhotos.net)