Pay attention to liquidity needs while selecting tax saving instruments

Investors in higher tax brackets may avoid products taxed at the slab rate

If you have not begun your tax-saving investments yet, it is time to start the process. Postponing it for the fourth quarter could result in a cash crunch. Tax-saving related mistakes occur primarily when investors choose products in haste at the last moment. Also, these investments should not just be made for tax saving; they should also help the investor achieve his financial goals. Here are a few common mistakes that should be avoided:

Investments not linked to goals

People often choose products like equity-linked savings schemes (ELSS) because their past returns are good. But before doing so, the investor should check if his risk profile, investment horizon and asset allocation permit him to invest in an equity product. If not, he should opt for a fixed-income instrument. “A variety of products allow you to get the benefit of tax deduction under Section 80C, such as Public Provident Fund (PPF), Unit Linked Insurance Plan (Ulip), Voluntary Provident Fund (VPF), and so on, all of which have different tenures and risk profiles. Choose a product that is in sync with your goal and risk profile,” says Anil Rego, founder and chief executive officer (CEO), Right Horizons.

Not knowing tax implication

Investors also need to understand how the returns from these investments will be taxed. “The interest earned from National Savings Certificate (NSC) and five-year tax-saving bank fixed deposits is taxable at the slab rate. This makes these fixed-income investments unattractive for individuals in the higher tax brackets,” says Pankaj Mathpal, founder and managing director, Optima Money Managers. They would be better off contributing to a product like PPF, whose returns are tax-free (provided they have the required investment horizon).

Making last-minute investments

Investments for tax saving should be done from the start of the financial year, instead of only in the last quarter. Calculate your tax liability at the beginning of the year and then plan your tax-saving investments accordingly. “Investing regularly will help reduce the burden of investment in the last quarter,” says Rego.

Often, mistakes in selecting the right tax-saving product happen because of the last-minute rush. The last days before the financial year ends is the period when maximum mis-selling happens.

By investing at the last moment, investors also deprive themselves of the benefit of rupee-cost averaging. “In the past few years, markets have been peaking in the last quarter of the financial year. So, one would end up buying market-linked investments like ELSS at a higher price,” says Rego.

Ignoring liquidity needs

Consider your liquidity needs when selecting a tax-saving investment. Most tax-saving investments have long lock-in periods and can’t be sold easily to generate cash. There are also penalties for early exit. Investing in PPF does not help if you have a short time horizon, since the total tenure is 15 years, and partial withdrawal is permitted only after five years. Similarly, Ulips come with a five-year lock in. ELSS has the shortest lock-in of three years. “Agents often push insurance products for tax saving. Investors get stuck in them as they have low liquidity,” says Mathpal.

Clubbing insurance and investment

Keep your insurance and tax-saving investments apart. “Traditional life insurance products, which combine both, offer returns that are lower than PPF, NSC and other small-savings schemes. They also have long tenures, low liquidity, closure penalties and low returns,” says Archit Gupta, founder and CEO, Clear.

Over-diversification

Spreading your investments across time frames and asset classes helps reduce risk and improve liquidity as the different instruments mature at various points of time. However, too much diversification does not help. Investors could lose track of their multiple investments. “Spreading investments across too many schemes is not advisable. If you are investing in ELSS, stick to one-two schemes. If these schemes are doing well, don’t add a new one every year,” says Parul Maheshwari, independent investment advisor.