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Tax saving schemes: Wait till March 2007

The finance ministry is considered changing the tax benefits given to many tax saving schemes (Check: Personalfn,Economic Times and My Blog)

Next year’s budget may remove some of the tax exemptions provided under 80C and reduce the personal tax rate. Moreover, some of the exemptions provided may continue, but may be taxed on exit. So if you put in Rs. 100,000 today into a tax saving fund, you will save Rs. 30,600 (highest bracket) tax; but if the ministry has its way, the entire corpus will be fully taxed when you use this money, usually unlocked three years later.

But this deal may still be worth the effort, versus “ditching” tax saving schemes completely. Here’s the logic:

Assumption 1: You have 1 lakh to invest in some tax saving investment.
Assumption 2: In three years, your money grows by 70%.
Assumption 3: FM declares that 80C investments are fully taxable on exit, and tax rate is down to 25%. No change to Long Term Capital gains etc.

Scenario 1: You invest the 1 lakh in tax saving funds today.

Tax today: nil.
Net value after three years: Rs. 170,000 (70% in three years)
Tax if you exit: Rs. 42,500 (at 25%)
Real value to you : Rs. 127,500.

Scenario 2: You pay your tax today, and invest in a diversified fund instead.

Tax today: Rs. 30,600 (at 30.6%)
Net value today: Rs. 68,400.
Net value after three years: Rs. 116,280
Tax if you exit: Nil (no long term capital gains)
Real value to you: Rs. 116,280.

So there is a value is investing, providing the tax rate comes down to 25%. What if tax rate stays at 30.6%, and the FM still taxes investments on exit?

Net values after three years:

Scenario 1: Rs. 117,980
Scenario 2: Rs. 116,280 (stays the same)

The difference is only Rs. 1,600! And for that difference you have to stay invested for three years, and lock in your money.
It’s better then to stay away. And as seen lately, diversified funds seem to do a better job of managing money than tax
saving funds, so you might just make this difference by higher returns. No lock in, same returns, a much better deal in general.

The budget is usually revealed in the last week of February. You have time till March 2007 to make
your 80C investments. You may have to consider the budget proposals carefully; Calculate whether it makes sense, and only if there is a substantial saving, go on.

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