Save tax with the Sheltering Principle

You should protect from tax, those investments that provide the lowest post-tax returns

It is better to have income and pay taxes than not have income. But it is important that you carefully plan your taxes. In this article, we look at how you can avail deduction of ₹1.5 lakh under section 80C of the Income Tax Act as part of your goal-based investments. The following discussion is based on the assumption that you choose the old tax regime.

Tax-efficient investments

Saving taxes on your goal-based investments helps you enjoy a better lifestyle. How? The higher the taxes on your goal-based investments, the lower the returns. And lower the returns, the more you have to save every month to achieve your goal. Therefore, tax-efficient investments will leave more money for your current consumption.

Therefore, it is important that you optimally use your Section 80C limit. What products should you choose to achieve your life goal and simultaneously exhaust the Section 80C limit?

For any goal that you pursue, your investment portfolio will have equity and bonds. Your equity investments will be typically through mutual funds (MFs) while your bond investments will be in bank fixed deposits (FDs) and recurring deposits (RDs). So, your equity investments predominantly earn capital appreciation whereas your bond investments earn only income return. This sets the stage for applying the Sheltering Principle to create tax-efficient portfolios.

The principle in question

You should protect (shelter) from tax those investments in your portfolio that provide the lowest post-tax returns.

Typically, income returns are taxed at a higher rate than returns from capital appreciation. Note that your equity investments will typically attract long-term capital gains because you are likely to hold the investments for more than one year; this is because you are investing to achieve a life goal which will have a typical horizon of more than three years.

Therefore, your equity investments will be taxed at 10% whereas your income returns will be taxed at your marginal tax rate (30% typically).

So, if your goal-based portfolio contains equity funds and bank FDs, your investments will suffer 10% tax on equity investments and 30% tax on bond investments. Therefore, it is logical to shelter bond investments (PF and PPF) from taxes. The arithmetic behind the Sheltering Principle is simple. Suppose you are planning to invest ₹1.5 lakh in PPF and your total investments for the year is, say, ₹4 lakh.

Suppose PPF pays 7% per annum, your portfolio’s expected portfolio return will increase by 0.79% (7% times your marginal tax rate times ₹1.5 lakh divided by your total annual investments). This shows that the benefit decreases as your total investments in a year increase. There is some benefit, nevertheless.

There is a reason why the Sheltering Principle works. The long-term capital gains on ELSS is taxed at 10% just like other equity funds. So, the benefit in investing in ELSS is only the amount you save as taxes in any year you make the investment, which is ₹45,000 (marginal tax rate of 30% of ₹1.5 lakh).

In contrast, by investing in PPF, you not only save ₹45,000 in taxes in any year you invest, your interest income and accumulated amount you withdraw at maturity are also tax-free. This adds to the post-tax expected return on your portfolio through the time horizon for a life goal. The higher post-tax returns reduce stress on savings, giving you more disposable cash for current consumption.

Note that investments in ELSS have a three-year lock-in period under the Income Tax Act. So, you risk losing your unrealised gains if the market moves up during the lock-in period only to decline thereafter. Also, if you invest in ELSS through a systematic investment plan (SIP), each SIP will be subject to the three-year lock-in period.

(The author offers training programme for individuals to manage their personal investments)

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