Tax and inflation implications for savings products

Tax and inflation implications for savings products

An individual’s personal tax position will have considerable influence on the choice of suitable savings products. 

Tax implications
The last quarter of the financial year is the busiest time for insurance agents and other financial advisers. It is during this time of the year that salaried individuals and others are busy tax planning and making investments in tax saving products to minimise tax deductions from their salaries. In fact it could be said that many people make investments purely to minimise their tax liabilities.

This is the wrong approach towards savings and investment, as there needs to be a proper financial plan in place before a particular investment product is chosen. In this section we will look at the tax implications for savings products.

Income Tax Act 1961
This Act came into effect on 1 April 1962 and has undergone several amendments since then. Every major amendment is effected through a Finance Act (at the time of the union budget presentation) and other amending acts. Additionally, the Central Board of Direct Taxes (CBDT) issues circulars clarifying the various provisions related to income tax.

When working on effective tax planning, it is important to understand the exemptions and deductions provided by the Government. The investor can take advantage of the following tax deductions under various sections of the Income Tax Act as per prevailing income tax rules.

Section 80C

• Under section 80C a deduction from taxable income is allowed for investments made in the following products: 

• Life insurance premium paid for traditional products.

• Unit-linked insurance plans (ULIPs).

• Pension plans.

• Repayment of the principal component of home loan.

• Employee provident funds (EPFs).

• Equity linked saving schemes (ELSs).

• Tuition fees paid for children.

• Five-year tax saving bank deposits.

• Public provident funds (PPFs).

• National savings certificates (NSCs).

• Senior citizen savings schemes (SCSs).

• Stamp duty and registration charges.

• Infrastructure bonds.

• Pension funds. 

• Post office time deposit – five years.

Section 80D
Section 80D allows deductions from taxable income for the premium paid towards health insurance for the individual, their spouse and children. For premiums paid for health insurance for parents, an additional deduction is allowed. For premiums paid for senior citizens, a higher deduction from taxable income is allowed compared to the deduction made for other individuals.

The amount allowed as deduction from taxable income is subject to review from time to time.

Section 80DD
Under this section a deduction from taxable income is allowed for expenditure (up to specified limits) incurred on medical treatment/training/rehabilitation for a disabled/handicapped dependant. The expenses can be for the treatment for disability, disease/ailment (as specified under this section) of the individual or a dependent relative. To take advantage of this deduction a certificate in the prescribed format needs to be produced by a medical practitioner.

Section 80E
Under section 80E a deduction from taxable income is allowed for the interest paid on an education loan.

Section 24(b)
Under section 24(b) a deduction from taxable income is allowed on the interest paid (subject to specified provisions) on a home loan.

Inflation implications
We looked at the impact of inflation on insurance cover in chapter 5. When considering financial planning the investor must make sure that the amount required for meeting future expenses is calculated taking into consideration the impact of inflation on the prices of goods. If inflation is running at 5% and you earn 8% on your investments in a bank fixed deposit, you would have earned a return of 3% net of inflation.

Of course, in real life the situation is not quite as simple as this. The inflation rate would not be exactly as predicted. It could be higher or perhaps even lower. It is always a good practice to assume a higher rate of inflation rather than the actual inflation rate for the past five or ten years when producing future calculations. The returns on investments may also be subject to taxation. Inflation and taxation together suppress the real returns which may turn out to be lower than the anticipated returns.

As a result, an investor has to make sure that the returns on their investments should be sufficient to provide them with enough income after taking into account inflation and tax deductions.

Implication of interest rates on savings products

Changes in interest rates will affect those offered by savings and investments products and can, therefore, have an adverse effect on the investment decisions of an investor.

In this section we will look at the effects of changes to interest rates.

Increase in interest rates
In the case of an increase in interest rates, the interest rates on deposits and loans go up. The decision to increase interest rates is made by the Central Bank of the country (Reserve Bank of India) when it is in the interests of the country’s economy to encourage savings and to discourage people from borrowing for unnecessary expenditure, and thereby reducing the demand for credit. The effects of an increase in interest rates are as follows:

• The demand for lending products from banks and financial institutions suffer as borrowing becomes expensive for the individuals and they postpone their purchases. 

• On the other hand, bank deposits with higher interest rates become more attractive and people choose them resulting in an increase in savings. There is also an increase in the purchasing of bonds which have higher interest rates. 

• However, a high interest rate scenario is not good for the stock markets. Borrowing becomes costly for companies which leads to higher interest payments. This can put pressure on the profitability of companies which can lead to the selling of shares and subsequently lower share prices.

Decrease in interest rates
In the case of a reduction in interest rates, borrowing becomes cheaper and there is an increase in investments made by companies. This is done to stimulate the economy so that there are more investments and an increase in the demand for goods and services in the economy. The effects of a decrease in interest rates are as follows:

• Low interest rates increase the demand for lending products. Investors take out loans for the purchase of financial assets, which results in increased consumption. 

• Investment in other financial products (like equities and real estate) is preferred compared to investment in bank deposits due to the low interest rates offered. 

• Investors who have already locked-in their investments at a higher interest rate in bonds and bank deposits are at an advantage when interest rates fall.

Anand Khemka
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