Tax Saving Instruments: Avoid Overinvesting in Them

Tax Saving Instruments: Avoid Overinvesting in Them

Tax saving instruments is a great way to invest your money while at the same time getting a tax incentive. Under the various sections of the tax code, there are limits specified up to which one can invest in these instruments to claim a tax exemption and hence get a reduced taxable income. However, it is often found out that due to lack of careful diligence, the amount that is actually being invested in these tax saving instruments is quite higher than the limit, making the additional amount locked in an investment with not so great returns. Factor in the opportunity costs that you incur by not investing that money where they might earn a higher return and it really starts looking like you drew the short stick.

Plan Your Investments
Carefully plan what and how much of your income you intend to divert into tax saving investments for deduction of taxable income. If you are well aware of how much money is being invested solely for the tax exemptions, you are free to invest the rest of what you can afford into high performance funds where tax issues are inconsequential. Simple objects like provident funds are also tax exempt, so it is imperative to do your research so that you know the various avenues where you can invest your money to get a tax deduction.

The Type of Investment
Note that investments in a tax saving instrument are often subject to a maximum cap of the amount up to which the principal will be deductible. Therefore it makes sense to not make recurring investments in such an instrument as invariably, the principal will cross the maximum limit of exemption and you will be stuck with an investment that performs average at best. Also since most recurring investments are mandatory, you will need to see them through or incur penalties, so you incur an additional opportunity cost as well.

Watch the Rate of Return
This is where things might get a bit complicated and quite a bit of mathematics gets involved, so if you are not comfortable with that or just want a professional to figure things out for you properly right at the get go, consider a tax consultant. Tax savings are great, but understand that these instruments are often not what might earn a great or even decent rate of return. Consider the amount of tax you are getting exempted from and compare it to the opportunity cost of not investing that money in a high performance mutual or index fund (or even stocks, if you are feeling adventurous). Which one is higher? In certain scenarios or market conditions, you can be much better served by investing your additional money in a fund with a high rate of return than chase after tax deductions.

Consider Your Goals
Tax incentivised instruments are generally designed to encourage long term investments, so consider your goals about investing before you choose which instrument to invest in. If you are saving up for retirement, tax deductible investments are a great deal since you save a lot of tax over the years (of employment up until retirement) and are not much affected by a lower rate of return simply because you do not intend to cash it in until later. If you are investing for a short term goal like a large upcoming expenses, tax savings at the end of the fiscal year are worthless to you and a high performance fund that can generate good returns is much better suited to this scenario.