High cost of tax saving

Tax planning, for must us form an important part of managing our finances. By using certain provisions under Income Tax act, one can save good amount of taxes. Some investments and expenses facilitate tax savings. However, sometimes pursuit of tax saving can prove expensive. This is typically the case when one takes investing decisions primarily to save taxes rather than fulfilling some financial objective. This often leads to high cost of tax saving!

High cost of tax saving

Here are some cases where pursuit of tax saving can actually prove expensive and increase the cost of tax saving!

1 – Investing in real estate to save taxes

Investing in real estate is a huge commitment. It requires sizable capital. Most of us cannot afford such capital and hence, end up taking home loan.

You can claim deduction on principal repayments under section 80C. (There are many more investment options under Section 80C, which you can take advantage of) In addition Section 24 (and in many cases, Section 80EE too) offers your tax decision under interest payment too. Together these can lead to sizable tax savings. Over the duration of the home loan, these tax savings can be really good. 

However, many people buy a home and take home loan just for the sake of tax savings it offers. And unfortunately several of them get into a long term financial commitment of paying off the home loan. This is a huge amount and usually runs into several of lacs. More often than not, there is no easy way out, if one wishes to. 

In that context you need to decide for yourself whether the tax saving is worth it or not.

2 – Buying endowment (and other random insurance) plans

This is arguably the most common of tax saving plan getting expensive! 

Endowment or money back plans or ULIPs offer triple “benefit” of investment as well as insurance, in addition to tax savings. However it ends up doing injustice to both. Returns are lesser than equivalent debt/ equity options available. Costs are usually high. And you end up being severely under-insured too!

(Related – Why should you not mix insurance and investments)

While there is a promise of returns and insurance, lot of people buy these insurance products just to save taxes. And then get committed to continuing these policies over the course of next several years.

In long run, this can increase the cost of tax saving. All because of wanting to save some tax!

3 – Investing ELSS

ELSS (Equity Linked Savings Scheme) can be a good product – for tax savings as well as returns. 

If history is anything to go by, ELSS can give give you good returns. Maybe, best among other tax saving investment options (albeit there is a risk). Equities and equity mutual funds have given good returns in past, and if economy keeps growing at a healthy rate, they can be expected to give good returns in future too.

However, lot of people jump into buying ELSS just to save taxes – which may be a wrong premise to invest. (Unlike investing for potential good returns, with tax benefit being an added benefit!)

4 – Investing without understanding the implication of lock in period

Most of the tax saving instruments have a lock in  period. For example PPF (Public Provident Fund) has a tenure of minimum 15 years (and can be extended). Provident fund penalizes early withdrawals. If you are contributing to NPS (National Pension Scheme), the lock-in can be much higher and you may be able to withdraw the amount much later in life (around retirement and beyond!)!

However, if you jump to making these investments just to save taxes, without understanding that lock in period can impede cash flow, then you may face some issues later. 

For e.g. if you are investing in PPF/ ELSS and NPS to such an extent that you don’t have much cash flow left otherwise, and you suddenly need some money (your marriage, buying a car, expecting a kid), then you may face a cash crunch. 

5 – Saving capital gains tax

When you sell a house (or any property) and need to pay capital gains tax, you can avoid it by investing either in another property or investing in specific government bonds. Often, people invest in either of the two options just to save taxes.

However, real estate requires lot of financial commitment and not everyone may be able to handle it. Worse, you may be stuck with it if you are buying it for tax saving rather than “investing”.

Returns on the government bond may be too less – and it will be illiquid for some time.  Do your own math and evaluate whether lesser returns (but helping in tax savings) is worth it?

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To sum up,

What’s the point I am trying to prove?

Tax saving, for most of us is important. But tax saving just for the sake of tax savings can lock you in in some unnecessary financial products or investments that may not be aligned to your financial goals.

Hence it is important to understand the nature of investments, and associated terms & conditions before buying a financial product.

Tax saving can be an important consideration – but should not be the only consideration! Beware of tax saving products which lead to high cost of tax saving!

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