Most common tax planning mistakes to avoid

Happy New Year everyone! Hope you had a great start to the year. We sure did!

The new year is a season of optimism and picking up on all pending stuff from last year. This is also the season of Tax planning!

Taxing times

“It is better to take many small steps in the right direction than to make a great leap forward only to stumble backward” This old Chinese proverb applies even to our “tax planning” exercise.

There is a rush to buy tax saving schemes during this last quarter. A common question on everybody’s mind is how to save more tax. People often complain about the tax burden and how it is affecting their wealth creation.

But what they really miss out on is a much bigger problem that is hindering the growth of wealth. That is considering tax planning as financial planning. There is so much focus on tax deductions that people miss out on paying attention to efficient financial planning.

But remember the two most important things before you start the tax planning exercise.

Firstly, financial planning should include tax planning and not vice-versa.
And secondly, one should do a thorough financial planning exercise at the start of the financial year rather than in the last quarter.

Mistakes we make

The history of Indian taxation is about 2300 years old. Tax payments are certain, but many of us postpone the tax planning exercise to the eleventh hour. Too many schemes and changing interest rates on them, make this exercise even more cumbersome. This often results in making hurried investments in tax-saving but low-returns generating options.

Some of the common mistakes we tend to make are:

Investing purely to save tax

We Indians, usually first choose a tax-saving product and then somehow fit them into our financial goals. In fact, 90% of our investment decisions happen around tax planning. Just look out for any new scheme that has a tag of “Save Taxes”. They often attract most retail investors. This way, we end up locking in money for five, six years, or even more and thus, commit the most common blunder – investing purely to save taxes, without understanding the opportunity cost.

Lured by guaranteed returns

We Indians have grown up stacking all our investments either in gold ornaments or bank FDs. Our love for safety and guaranteed returns are also reflected in tax planning. PPF and other fixed-income investments are popular tax saving schemes, but sometimes do not even beat inflation and come with a long lock-in period. Tax saving mutual funds or ELSS on the other hand have historically generated better returns over the longer period and also generate compounding gains. We understand that some investors are risk averse. But if your age, income, and investment horizon allow you to take some equity exposure, it is advisable to take a calculated leap of faith.

Tax planning = Higher savings

We often keep loans alive just for the purpose of tax saving as the interest portion of the EMI paid for the year is tax deductible up to a maximum of Rs 2 lakh. This as well as other expenditure- based options in Sec 80C do not lead to more wealth generation. Also, the overall benefit is limited to 30% of interest cost only. Therefore, the amount of tax saved is very small compared to the total interest outgo. By simply keeping the loan active for tax saving purposes, we are losing out on substantial wealth generation opportunities, had we invested the EMI money in better financial instruments.

Not looking beyond 80C

For many, tax planning starts as well as ends with Section 80C of Income-tax Act, 1961. This leads to a sub-optimal reduction of your tax liability. Lets understand this with the exampls of National Pension Scheme (NPS). Every year, you can claim a deduction up to Rs 1.5 lakh under Section 80C. But in case of NPS, a total tax benefit of up to Rs. 2 lakh is allowed under Section 80CCD (1) and Section 80CCD (2). This means, if you fall under the 30% tax bracket, you can earn additional tax savings of Rs 15,000 by investing in NPS.

All losses are bad

No one likes to lose money in their investments but sometimes we do end up investing in lower-quality funds or stocks. Investors can reduce their tax arising from capital gains by booking capital losses along with it. This way they can get rid of some of their loss-making investments and reinvest the proceeds in better funds. This strategy works because you are allowed to set off capital loss against the gain. However, investors need to be careful about the type of capital loss they are booking. While short-term capital loss can be set off against short-term and long-term capital gain, long-term capital loss can be set off only against long-term capital gains.

Bottomline

There are various tax-saving options whereby you can save quite a bit of taxes. But always remember, tax benefits shouldn’t be the primary reason for you to go for an investment product, insurance, or loan. 

P.S. For a ready reckoner, we have compared some popular tax saving schemes across parameters like risk, return, liquidity, etc. to help you make a more informed choice

*SSY – Sukanya Samriddhi Yojana

*EEE – Exempt Exempt Exempt. This means that the amount invested, withdrawals and capital gains, all are tax free

Cheers,

Ruchi Mehta

https://www.linkedin.com/in/ruchimehta-tavaga/

Disclaimer: This write-up is solely for educational purposes. This in no way should be construed as a buy/sell recommendation. Please consult your investment advisor before investing.

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