- Any investment you make passes through three stages- Investment, Accrual and Redemption
- Based on the taxation element on three stages, investments classify into three categories — (1) Exempt-Exempt-Exempt (EEE), (2) Exempt-Exempt-Taxable (EET) and (3) Exempt-Taxable-Exempt (ETE)
- Understanding the tax incidence on various instruments should help you make a better choice when it comes to investing
Benjamin Franklin once said, “in this world, nothing can be said to be certain, except death and taxes.” However, we often tend to ignore the tax incidence of various investments we make. It is only at the time of filing of income tax return that our tax consultant makes us aware of the impact of such gains. It may be possible that tax incidence may be making one investment beneficial or otherwise. For example, a fixed deposit offering 8% may be considered a better investment than a tax-free bond offering 7.5%. However, in reality, the investor in tax free bonds may emerge end up getting higher returns post-tax as the interest received on fixed deposits is taxable while interest on tax-free bonds is exempt. Let us say you fall in the highest income bracket and you pay 30.9 per cent as tax, then the post-tax return on a 5-year bank fixed deposit of 7 percent is 4.8 percent per annum!
Accordingly, this article aims to help you understand tax impact for your various investments by classifying the same depending upon their tax incidence. Any investment you make passes through three stages :
1. Investment - When you make an investment
2. Accrual - When such an investment earns some returns
3. Redemption - When you redeem your investments and receive an amount equal to the principal invested and the gains, if not received earlier.
There may be a tax implication for your money at each of these stages. As such, the tax-saving investments classify into three categories — (1) Exempt-Exempt-Exempt (EEE), (2) Exempt-Exempt-Taxable (EET) and (3) Exempt-Taxable-Exempt (ETE). Let us understand each one of these one by one.
Such investments are deductible at the time of making investments. Further, the returns are exempt at the time of accrual and further, the income received at the time of maturity/ redemption is also not subject to taxation. Such a unique status is enjoyed by long-term investment instruments like Public Provident Fund (PPF), Employees’ Provident Fund (EPF), etc. Unit-linked insurance plan (ULIP) offers investment and insurance in a single structure. It not only provides life insurance but also helps channel savings into market-linked assets to fulfill long-term goals.
In most ULIPs, there are different asset allocation options between equity and debt. A ULIP can have a duration of 15 or 20 years or more but the lock-in period is five years. Any switching between the fund’s options irrespective of the holding period is exempt from tax.
As it is clear from the name, the investment benefits from tax deduction at the time of investing and further, the accrual of income/ accumulation stays exempt from tax. However, at the time of withdrawal, a tax is required to be paid on the maturity amount. For instance, if you fall in the 20% tax bracket and the rate of return on your investment is 8%, you will lose out 20% of that return and make only 6.4% on your investment.
As such, the tax benefit availed earlier on the principal is withdrawn at the time of redemption. So, effectively, you just end up postponing the tax till the time you withdraw/ redeem the amount. For instance, in National Pension Scheme (NPS) the withdrawal through a monthly annuity is taxable. However, recently NPS tax provisions have also been changed to exempt 40% of the corpus from tax incidence if withdrawn.
For instruments with ETE status, a tax is paid only for the returns accrued at the time of accrual. The investment gets eligible for tax deduction, and the redemption/ maturity amount continues to stay tax exempt as well. However, you will be required to pay tax as and when the interest accrues. An example of such instrument is Tax Saving 5-year Fixed Deposit.
As such, understanding the tax incidence on various instruments should help you make a better choice when it comes to investing.