Here's how you can save tax

The Union Budget 2005 will go down as a significant step towards encouraging individuals to plan their finances better. The step -- bringing parity in terms of both investment limits as well as tax benefits with respect to savings based instruments like life insurance and tax saving mutual funds.

This new regime has got a lot of investors thinking on whether they should realign their 'tax saving' investment portfolio in favour of mutual funds. In this article, we work out whether or not such an option is feasible.

An endowment policy is a life insurance plan, which covers your life for a predetermined amount, i.e. the sum assured. On maturity of the policy or in case of an eventuality, apart from the sum assured, you also get the accumulated bonuses that have been generated.

Life insurance companies are mandated to invest predominantly in debt securities (this is true for regular insurance policies that are distinct from ULIPs). On the other hand, a tax-saving fund is a diversified equity fund.

It works like an open-ended diversified equity fund that invests predominantly in the stock market to generate growth by way of capital appreciation. The only difference between an equity fund and a tax-saving fund is that the latter has a 3-year lock-in and tax benefits under Section 80C.

To that end there is a common ground between tax-saving funds and endowment plans in the shape of Section 80C tax benefits.

But how do individuals who have already purchased an endowment policy evaluate the option of shifting to tax saving funds? An illustration will help in understanding things better.

Endowment plan from ABC Company Ltd

Suppose an individual aged 30 years, had bought an endowment policy for a sum assured of Rs 1,000,000 with tenure of 15 years. The annual premium for this plan works out to Rs 65,070. The maturity amount on completion of 15 years for this plan is Rs 1,684,000 (assuming a 10% rate of return as per company illustrations).

But if one were to take a closer look at the returns, it is not really 10% (i.e. on Rs 65,070) as shown in the illustration. That is because the returns calculated by the insurance company are actually computed on the amount net of expenses, i.e. after accounting for expenses. The actual returns therefore work out to approximately 6.55%.

Now lets assume that the individual wants to surrender his policy and shift his premium money to tax saving funds. If he decides to surrender this policy after say, 5 years, the surrender value works out to Rs 288,778 (assuming a 10% rate of return according to company illustrations).

He can invest this money and also shift his balance premium payments to tax saving funds; simultaneously he can cover himself with a term plan.

What's in it for you?

If the individual decides to invest the surrender value of Rs 288,778 in tax saving funds for a period of 10 years, assuming a 10% rate of return, he would get Rs 749,015.

Term plan from XYZ Company Ltd

Since he does not have an insurance cover now, he will also have to buy a term plan. The cost of buying a term plan for the individual, at the age of 35, with a sum assured of Rs 1,500,000 with a 10-year tenure will cost him Rs 4,350 p.a.

Investments in tax saving funds

Also assuming that he shifts the remaining yearly premium amount of Rs 60,720 (Rs 65,070 - Rs 4,350) to tax saving funds for the 10-year tenure, he will get Rs 1,064,492. The total maturity value will amount to Rs 1,813,507 (i.e. Rs 749,015 + Rs 1,064,492).

That's more than what the individual would have received on maturity of the endowment plan, had he decided to stay put in it.

And that's not where the comparison ends. The individual will also stand to benefit by keeping his insurance and investment needs apart. If an eventuality were to occur, the individual's nominees would not only stand to gain the sum assured on the term plan (i.e. Rs 1,500,000) but would also benefit from the amount that had been invested in the tax-saving fund.

Investments in tax saving funds can be redeemed after a minimum lock-in period of one year in case of an eventuality to the investor.

But the above argument of shifting from an endowment plan to a tax saving fund comes with a few riders attached to it. Individuals need to have a stomach for risk before investing in equity oriented mutual funds.

Only if they are able to bear the ups and downs of the stock markets and can stay invested for the entire duration should they consider investing in such funds. The above example was taken as a case study. The actual values shown may differ across various insurance companies and tax saving funds with differing parameters like the age, sum assured and type of insurance plan amongst others.

Insurance companies also declare bonuses regularly on their endowment plans. Once a bonus is declared, it becomes mandatory on the part of the insurance company to pay the same to policyholders.

As such therefore, there's an element of guarantee attached with bonuses, which is not the case with tax saving funds. Investors could lose heavily in case of a sharp decline in the markets. Individuals therefore, need to keep in mind their risk appetite before zeroing in on any option.

Life insurance companies have also realised the importance/promise of market-linked instruments, which in the long run, have the 'potential' to offer better returns as compared to their debt counterparts. Most of these companies now offer 'Unit Linked Insurance Plans (ULIPs)'.

ULIPs are market-linked life insurance plans, which are equipped to simultaneously offer market-linked returns and a life cover. Individuals who have a risk-taking propensity, could consider investing in ULIPs.

So does all this mean that endowment plans should be given a miss? Quite the contrary. An endowment plan can act as a safe investment avenue that offers insurance cover. On the other hand, tax saving funds (powered by the presence of equities) can add the much-needed gusto to your portfolio; while a term plan can cover the individual for a higher sum assured at a lower cost.

Individuals should therefore take into consideration various factors like their risk appetite, current portfolio mix and investment objectives while conducting the tax-planning exercise. This will help investors select the suited avenues and build the right tax-planning portfolio.

(The above illustrations are those for existing life insurance companies. The figures may differ across various companies)

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