Small savings: Big on tax benefits!

Despite the emergence of 'evolved' tax-saving products like equity-linked savings schemes (ELSS) which combine market-linked returns with tax sops, the small savings segment continues to be a popular investment avenue. Traditionally schemes like Public Provident Fund and National Savings Certificate have been associated with attractive returns and tax benefits.

Most importantly these schemes offered assured returns thereby appealing to a large section of the investor community.

While rationalisation (read lower interest rates) in the small savings segment has taken some sheen off these schemes; Finance Bill 2005 has also done its bit by reducing the tax benefits. In this article we profile the various small savings schemes available to investors and find out how they measure up.

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For the purpose of our discussion, we have chosen schemes which offer tax benefits at the time of making investment under Section 80C, i.e. Public Provident Fund & National Savings Certificate.

Public Provident Fund (PPF)

Investments in PPF earn a return of 8% per annum and the scheme runs over a 15-year period. Investors are required to make contributions every year to keep their PPF accounts active thereby ensuring regular savings. The minimum and maximum investment amounts per annum have been pegged at Rs 500 and Rs 70,000 respectively.

Withdrawals from PPF are only permitted after completion of 6 years from the end of the financial year in which the first deposit was made; the amount which can be withdrawn is a factor of the balance present in the PPF account during the earlier years.

As a result, PPF scores rather poorly on the liquidity front. Secondly, although the scheme offers assured returns, the interest rate on PPF can be changed (the rate is reviewed every year). Hence in a softer interest rate regime, the interest earnings from a PPF account could shrink and vice versa.

However the scheme scores high in terms of tax benefits. Investments up to Rs 70,000 per annum are eligible for deduction under Section 80C; further the interest earned is tax exempt under Section 10 of the Income Tax Act.

PPF can be an ideal tool while planning for long-term objectives like one's retirement or children's education and marriage.

National Savings Certificate (NSC)

NSC investments offer a coupon rate of 8% per annum with a half-yearly compounding. The investment tenure is 6 years and the rate of return is locked at the time of investment, i.e. unlike PPF, investments in NSC are both assured and fixed.

These investments qualify for Section 80C benefits; Rs 100 per annum being the minimum investment amount and Rs 100,000 per annum being the maximum.

Like PPF, NSC also scores poorly on the liquidity parameter. Premature encashment of investments is only permitted under specific circumstances such as death of the holder(s), forfeiture by the pledgee or under court's order.

Interest earned from NSC was exempt under Section 80L in the erstwhile tax regime. However, Section 80L was omitted in Finance Bill 2005. As a result interest earnings from investments in NSC are now fully taxable.

NSC will appeal to investors who have a relatively shorter investment horizon (vis-à-vis PPF) and would like to lock their earnings rate at the time of investment.

NSC versus PPF: Post- tax returns

(*Education cess charged at 2.00% has been considered while computing post-tax returns.)

The table above seems to suggest that investors are better off investing in PPF on account of the tax-free earnings. However a vital factor has not been factored into the table above, i.e. EET (exempt-exempt-taxed). In the Finance Bill 2005, the finance minister threw up the possibility of adopting the EET system of taxation unlike the EEE (exempt-exempt-exempt) one being followed at present.

Let us understand what this means. At present the EEE method is used for taxation of savings i.e. contributions to specified schemes are exempt from tax, accumulation (earnings on investments) is exempt from tax, similarly withdrawals/benefits from the schemes are exempt as well.

It has been proposed that the EET method be adopted going forward; hence while contributions and accumulations would continue to remain exempt, the withdrawals/benefits could be taxed. A committee was set up to work out a roadmap for moving towards the EET system and to examine the instruments that would qualify for the new regime.

While we are yet to see any findings of the committee, investors would do well to realise that schemes like PPF among others might undergo a transition in the new tax regime. Further, there would be a need to evaluate PPF's attractiveness in light of the prospective scenario.

What should investors do?

It would be fair to say that investors are presently faced with a rather fluid situation, in terms of tax implications on investments in the small savings segment. Our advice to investors: concentrate on your needs and preferences rather than the tax implications while making investments. Select PPF or NSC based on how well each scheme is equipped to fulfill your financial goals.

In fact, investors should consider investing in both the schemes as it would make greater sense from the diversification perspective. The allocation to each scheme can be determined based on your needs, for example if your investment objectives are predominantly of the long-term nature, a greater portion should be allotted to PPF.

Conversely, if you are keen on building a relatively (vis-à-vis PPF) short-term portfolio wherein the maturity amounts are known with a greater degree of certainty, then higher allocations should be made in NSC.

While the importance of tax-planning cannot be undermined, it should certainly not take priority over or dictate your overall financial planning process.

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