So, did you file your Income Tax returns on time? How stressful was it? It’s been 10 days since the last filing date, so tell us, what are some decisions you regret taking? Tweet at us.
Moving on. Did you invest your money in some scheme just to save tax? or did you invest to build wealth? We know this would have been your biggest dilemma during tax filing.
So, in this blog, we will discuss which is better, Tax-saving or wealth-building.
Estimated read time: 3 minutes and 28 seconds
Hint: Avoiding stupidity is easier than seeking brilliance – Charlie Munger
Buckle up, here we go!
For a long-time, I wanted to save up as much tax as possible because I didn’t feel like paying much.
I used to utilize all the deductions available. Thought little about returns or beating inflation. I was very naïve. Paying tax felt like someone is snatching my polo candy from me.
But what has changed now? I learned more about how inflation affects my finances and the opportunity cost of my investments. Learning about these concepts in deep has made me think about the long-term consequences more than the short-term ones.
Let’s understand these consequences with an example.
Say you are earning a salary of ₹12 lakhs per annum, that is ₹1 lakh per month.
You want your portfolio to be allocated equally among equity and debt. But just before tax filing, you discover that after claiming all your exemptions and deduction, your taxable income is ₹6 lakhs. You made a mistake in the calculation, so now you have to pay tax.
But your friend suggests you invest ₹1 lakh in PPF and bring your taxable income under ₹5 lakhs to pay nil tax. It seems like a smart move, isn’t it?
In the short term, just to save on tax, you invested the lump sum amount in PPF, but what are the long-term consequences?
First, your portfolio asset allocation has changed. Your portfolio consists of more debt than equity. Your overall portfolio returns would be lower than planned because PPF provides a low return than equity investments.
Second, liquidity in PPF investments is low. There is a lock-in period of 15 years. Even though they allow partial withdrawals with conditions, the overall liquidity is low.
Third, opportunity cost. What if you have invested the amount in equity based on your asset allocation plan? Let’s do some math because numbers never lie.
Saving Tax Plan:
Plan A – You invested ₹1 lakh into PPF to save tax. For simplicity, assume you withdraw this amount only after the 15-year lock-in period is over.
So by investing in PPF in the current year, you save ₹33.8k in taxes. Let’s say the return on PPF investments is 7% throughout the 15 years.
The ₹1 lakh investment grows into ₹2.75 lakh in 15 years. And this entire amount is tax-exempt. Hurray!!!
Also, let’s say you invested the ₹33.8k you saved in taxes in equity with 12% returns over 15 years. That grows into ₹1.85 lakhs.
Thus, ₹2.75 + ₹1.85 = ₹4.6 lakhs.
So the total wealth you built in Plan A is ₹4.6 lakhs.
Building Wealth Plan:
Plan B – In this plan, based on your asset allocation, you invest ₹1 lakh in equity. And that makes you pay tax on the taxable income of ₹6 lakhs in the current year. The tax amount is ₹33.8k.
Your equity investments grow at 12% over 15 years and build a corpus of ₹5.47 lakhs. That’s amazing, right? But what about the taxes?
Long-term capital gains exemption helps you deduct ₹1 lakh of profit every year. Assuming you will smartly harvest these profits every year, you end up paying no tax for this. Harvesting a profit of ₹4.47 lakhs in 15 years is a doable plan.
Thus, 5,47,000 – 33,800 (present year tax) = 5,13,200
So the total wealth you built in Plan B is ₹5.13 lakhs.
Isn’t this wonderful? With Plan B, you build an extra corpus of ₹53k while paying tax, sticking to your asset allocation plan and with better liquidity.
You just saw how an investment of ₹1 lakh can make a difference in your future wealth. Just so you know, if you had made this mistake with ₹2 lakh, you would have lost an opportunity to build an extra corpus of around ₹1.9 lakh.
What if you repeat this mistake every year or with a higher amount? Think about the dent it will leave on your wealth.
We know we have oversimplified it by making some assumptions. The main point is to take investment decisions with a wealth-building mindset and not solely to save on tax.
We are not asking you to stop claiming exemptions and deductions. We suggest always making an investment plan beforehand based on your risk appetite, goal timeline and desired returns. If these investments help you save some tax, that’s great, but don’t invest solely to save tax.
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