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Commentary

New Tax Code: EET Regime and Tax Saving Schemes

The new Direct Tax Code is out (full draft) and proposed to cut taxes dramatically starting 2011. From a current slab of about 1.6 lakh, 3 lakh and five lakh (10%, 20% and 30% rates) – the new slabs will be 1.6 lakhs, 10 lakhs and 25 lakhs.

The flip side of it? Most deductions are out, and it’s a simplified bill. The lower rates will encourage compliance and weed out complex avoidance schemes.

But there are tons of online sites that talk about all the stuff in the code. Let me focus on one thing: the EET regime.

EET refers to Exempt-Exempt-Taxed. Upto 3 lakh a year starting 2011, certain investments – and I think by this they mean insurance, ELSS mutual funds, PPF and so on – will be exempt from tax in the year of investment. Then, as they grow in size, the growth is also exempt. Finally, when you withdraw the money the entire amount is added to your income and taxed.

Currently we have EEE – insurance and ELSS funds are exempt at entry, exempt on growth and exempt on exit. The limit is only 1 lakh a year.

Still, 2011 is hajaar far away – two more financial years away, in fact. Why should you bother? Because the EET regime changes a few things.

Investing money in tax saving instruments now will be taxed on exit – because they will exit only after 2011 (lock in is three years, minimum). So if an insurance agent tells you to buy an insurance policy because it’s tax-saving, he’s pfaffing – you will end up paying tax when you exit.

(This doesn’t apply for PPF apparently; the tax code has a grandfathering clause that lets any accumulated balance in PF accounts as of March 31, 2011, stay untaxed even afterwards)

But it may still be worth it. A person earning 8 lakhs today will pay 30% tax on the 1 lakh invested. Should he get scared of EET and ditch? Well, he will get 70K today, out of that 1 lakh. But if he held for three years, and say there was zero growth, he will get 1 lakh in 2012, at which time let’s say his income is 12 lakh. The 1 lakh he gets then will be charged at 20% only, a 10% saving. (It may not be much, but there is a saving)

But in all the participation in insurance and Mutual Funds should reduce today, even though the tax code only gets valid in 2011. At least till 2011, because one can get a better deal investing in a PF instead. Not very positive in the short term for MFs/Insurance companies.

Another impact of the tax code will be that interest on housing loans may no longer be exempt from tax. I’m not sure about this, though. And STT will go – which means long term cap gains tax is back.(sell all long held stocks and buy them back in March 2011!)

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