The Budget for FY21 (April 2020 to March 2021) has brought a new tax system with a reduced rate and favorable slabs for those who are willing to let go of the exemptions. See this to find whether the optional tax system is beneficial for you.
If you have decided to opt for the new system, most of the exemptions given to tax-saving investments/insurance products currently do not apply to you. Both Insurance and Investments are important aspects of one’s personal finance plan and this shouldn’t be abolished because of a change in tax rules. That being said, if you are already investing in certain kinds of products just for tax savings, this could be a good time to review and make changes to benefit you.
The most important rule remains the same under the existing system or the new system. Tax saving shouldn’t be an objective, it should be an incentive. It means one shouldn’t take an insurance product or start an investment just for the sake of tax savings, for example, a good tax saving investment should be a good investment first! see below on what to do with existing Insurance and investment plans under the new tax system.
One should always have health insurance and one with financial dependents should always have life insurance, irrespective of the tax incentives. It is a common practice among Indians to invest in endowment kind of hybrid products, which does not offer good returns or adequate life cover. Most often, these are taken in a hurry in March by sales push, justified by the tax savings of these products under section 80C.
What to do: consider switching to term insurance plans for life cover. For the same life cover, term insurance premiums are a fraction of that of endowment plans. You may switch to a new term plan with adequate life cover*1. Use the difference to start investments of your choice. You will save a lot with a simple investment + Term insurance combo compared to an endowment/money back plan with the same life cover*1. If one is not comfortable with equity investments or planning to invest for the short term, do invest in Debt based mutual funds or traditional bank fixed deposits. If one is planning to invest for the long term, consider equity-based mutual funds. Do mind the penalties of exiting insurance policies prematurely. In general, exiting them in the initial years have been net beneficial even after considering the penalty.
The key point here is, whatever you do, do not stop investments just because there is no longer a tax exemption for investments. See below on what to do with the most common tax-saving investments under the existing system.
Tax Saving bank FDs: A tax saving FD is locked in for 5 years. Both tax saving FD and normal FD are taxed the same during interest accrual, hence one may invest in normal FD instead of Tax Saving FD. For favorable tax treatment during the investment and at the time of redemption, consider Debt based mutual funds.*2
Public Provident Fund: PPF is not taxed during the course of investment or at the time of withdrawal. This makes a case of investing in it in the new tax system as well (for anyone who is not comfortable with equity-based investments*3).
Equity Linked Savings Scheme: ELSS funds are similar to Diversified (Multi cap) Equity mutual funds, ideal for long-term investing. The limitation with ELSS is, every investment in it is locked for 3 years. If you think you have selected a good performing fund and you are happy with the performance, you may continue to invest in the ELSS funds, otherwise, you may do your fresh investments in Diversified (Multi cap) Equity mutual funds.*4
Personal finance planning is more important than tax planning. Decide your insurance requirements, identify your financial goals, plan your investment requirements, once this is completed, select suitable products considering any tax incentives. Make this change in tax rules – a reason to review your personal finance. Make it worthwhile, a plan focusing on you rather than the taxman or salesman.
Happy investing 👍
*1 If you have financial dependents, Consider starting a term insurance with adequate life cover, which is around 10 times your annual income
*2 Interest accumulated in a bank FD is taxed every year, irrespective of whether the FD has been closed or not, interest has been paid or not. The interest is taxed at the rate of tax slab of the investor. In the case of Debt mutual funds, no tax is applicable until the investment has been redeemed. At the time of redemption, if the investment has been held for 3+ years, Debt mutual funds are eligible for long term capital gains, which is 20% and calculated after indexation (adjusting for inflation) which again causes less tax outgo for most of the investors (depends on tax slab)
*3 PPF is a debt-based long-term investment product. Ideally, any long-term investment product should be equity-based. Even though equity mutual funds have capital gain tax at the time of redemption, historical data suggests an investor is likely to be better off with post tax return of an equity-based mutual fund compared to PPF.
*4 Valueresearchonline fund selector https://www.valueresearchonline.com/funds/selector/ is a good tool to compare among multiple fund categories.