Changes are in the air. With a new tax law, Direct Tax Code (DTC), coming in effect from April 2012, investors will have to change their tax strategies. The current DTC draft proposes some elementary changes in current taxation laws. Let’s find out what is changing and how will it impact your choice of tax-saving instruments…
Your saving limit tweaked
Till now, under section 80C, deductions up to Rs 1 lakh are allowed from gross total income. Investments, such as, payment of life insurance premium, tuition fees of children, ELSS (equity-linked savings scheme), ULIPs (unit-linked insurance plans), five-year bank deposits and provident fund contributions fall under this limit. Besides, there are specific deductions allowed for other expenses such as rent paid, donations and payment of premiums for medical insurance.
Government through DTC takes a clear stance of encouraging only long-term investments, i.e., options of investments of Rs 1 lakh has been curtailed to Government Provident Fund (GPF), PPF, Recognized Provided Fund (RPF), Employee Provident Fund (EPF), gratuity and pension scheme overseen by PFRDA. The aforesaid investments fall under EEE (Exempt-Exempt-Exempt — that is, no tax at the time of investing, on the accumulation / returns or on final proceeds on maturity). This means, the existing tax-saving instruments including ELSS, NSC, Fixed Deposits, senior citizen savings schemes, post-office deposits, etc., goes out of tax ambit and will attract tax from April 2012. All these instruments have short lock-in period and hence have thrown out of the window.
DTC law: Things to note
Your strategy: Re-align tax saving with your long-term goals. The best natural fit of tax-saving option will be retirement since all eligible options are retirement products. Investors should continue investing in these tax-free havens to the extent of Rs 1 lakh annually. You can do this by continue investing Rs 70,000 (maximum cap) in PPF. However, all the above mentioned instruments are debt-focused and one should take an overall asset allocation into account, before investing in debt. For instance, suppose you have Rs 4 lakh to invest in a year and want to put 25 per cent of the amount in debt – it is advisable to invest Rs 70,000 in PPF and the remaining amount in other approved funds.
Proposed changes in investments under section 80C of Income Tax Act:
| Existing 80C Deductions (Limit Rs 1 Lakh) | Proposed Under DTC | Your Strategy |
| - Equity linked mutual funds (ELSS)
- National Savings Certificate (NSC)
- Five-year bank fixed deposits
- Senior Citizens' Savings Scheme (SCSS)
- Post-office time-deposits
- Principal component of home loan repayment
| Tax benefit has been withdrawn, w.e.f., April 1, 2012. Investments in these instruments will now be taxable | Make one-time investment in these instruments during FY 2011-12. Park only the ideal funds after fully utilizing Rs 1 lakh limit |
| - Employee Provident Fund
- PPF
- Pension Contribution (including NPS)
| Contribution subject to deductions, with a maximum ceiling of Rs 1 lakh. All are available under ‘EEE’ treatment. | Build retirement corpus. Maximize your limit to avoid taxes |
| - Life Insurance (including ULIPs)
- Tuition Fees of 2 Children’s
- Health Insurance Premium
| An additional deduction of Rs 50,000 is available. | Take a term plan, thereby providing more room for health insurance deduction |
If you have surplus cash left to be invested in debt instruments, you can invest in NSCs, FDs, post offices deposits, etc., to meet your short-term goals. On equity side, sadly, there is no eligible instrument left for tax deduction. In the above mentioned example, Rs 3 lakh has to go as per your equity allocation, ignoring the tax aspect of investing. After all, your overall financial planning is worth more than saving taxes for a year.
This is to be noted that tax benefits in NSE, ELSS, etc., are only withdrawn from next year. Investors can still make one-time investments before March 31, 2011 and avail deductions under section 80C this year.
Separate deductions for insurance premium
Besides this, premiums paid for life insurance products (including ULIPs) will now be deductible up to Rs 50,000. Besides this, annual limit would also include the amount paid for tuition fees of children as well as medical insurance. Here, DTC enforces us to look at insurance, not as a financial product, but as an instrument for financial security of the family precisely due to following reasons:
- Combined cap of Rs 50,000 means that the amount claimed as deduction for life insurance premium needs to be lowered to make room for medical insurance and/ or tuition fees.
- A condition that premium paid is deductible, only if, it does not exceed 5 per cent of the capital sum assured (currently it’s capped at 20 per cent), also encourage low premium. To fulfill the condition one has to take insurance for longer duration, i.e., 20-25 years, so that you can claim deductions on your insurance premium
If this condition is not met, not only will you not get any tax deductions on the premium paid but even the income from the policy will be taxable.
Your Strategy: The revised DTC bill does not find a mention of deduction for payments towards annuity and deferred annuity products. We need some more clarity on this. Contribution made to some pension funds and ULIPs are also among those products, where tax exemption rules are not clear. So, the best option is ‘Term Plan Insurance’.
Take a term insurance for longer duration, i.e., at least 25-30 year. These plans are cheapest and would qualify for 5 per cent condition under premiums of insurance. Also, lower premium would leave ample scope to avail deductions on your medical insurance and tuition fee paid. On the contrary, a costly ULIP or a money-back policy insurance policy with a very large premium may eat up the total deduction of Rs 50,000. Plus you might have to pay taxes on maturity as well.
Real Estate: A mixed bag
From April 2012, the principal repayment of your home loan will not be eligible for tax deduction under DTC; however, the interest component will still qualify for tax exemptions. This comes as a huge blow to people paying large home loan EMIs and may now have to look for other tax-savings instruments. However, the loss is somewhat off-set from the gain, which one can derive from the removal of tax on notional rent on second house property. Till now, people who own more than one house are required to pay tax on notional rental income, even if, the second house is lying vacant.
Your strategy: Investment in a second home is now more tax-efficient. If you have sufficient funds, you can invest in a second house property and take advantage of higher interest component in initial years. However, if you are renting out your second house, benefit by taking major chunk (usually 5-6 months) of rent in advance. Under DTC, advance rent received from a tenant will be taxed in the year to which it relates, not when it was received. Advance tax received can be invested in short-term debt funds, partially offsetting the loss from taxability of principal repayment sum.
Mutual funds, stocks, real estate capital gains: Long-term investment brought under tax ambit
At present capital gain is not treated as ordinary income and has different tax rates depending upon the type of investment. For example, long-term capital gains from equity funds are exempted, whereas the same from debt fund is taxed at 10 per cent without indexation (on market rates) or 20 per cent with indexation (on market rates), which is lower. However, current DTC draft doesn’t differentiate between short-term and long-term capital gains and proposes to tax any capital gains after March 31 2012 in the year of withdrawal. Existing laws relating to capital gain tax and proposed under DTC are compared below:
Capital Gain Tax: Existing Vs proposed under DTC
| Equity | Debt | |||
| Present | Proposed Under DTC | Present | Proposed Under DTC | |
| Short-term capital gain | 15% | As per Tax-Slabs | As per Tax-Slabs | As per Tax-Slabs |
| Long-term capital gain | Exempt | As per Tax-Slabs | 10%* | As per Tax-Slabs |
Currently, capital gain will be treated as ordinary income and will be taxed as per the applicable income tax rates (tax slabs) after providing for deduction, the quantum of which is yet to be announced. The deduction will be tax-free. Also, the definition of ‘long term’ has been revised to at least one-year after the financial year, in which the investment took place. So, if any investment is made on October 1, 2010, to qualify as long-term it has to be held at least till March 31, 2012.
Your strategy: Here, you must try to liquidate your long-term holdings before March 31, 2012 to get tax exemptions on it. For fresh investments after DTC implementation, where on one hand, short-term investors will get benefits in lower income bracket; on the other hand, long-term investors will be taxed for what was tax-free earlier. But here, you must not re-align your investments with short-term perspective as you must invest as per your asset allocation.
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