Should you invest just to save tax?

Friday, May 10 2024
Source/Contribution by : NJ Publications

It is the start of the financial year! It is that time of the year when you upbraid yourself for delegating your tax filing for the last minute and making knee-jerk investment decisions at the end of the financial year to lower your tax burden that may backfire.

Manytimes, in a rush to invest ahead of the tax filing deadline, people tend to miss out on considering fundamental investment factors such as financial objectives, risk tolerance, return expectations and time horizon. So, the question arises: Should we invest just to save tax? Investment or Tax saving: which one should be our priority?

Of course, saving taxes is important, but it shouldn’t be the only factor driving investment decisions. Investing solely for the purpose of tax savings may limit the scope of financial growth. The key is to combine investments with sound financial planning to reduce tax burdens and foster wealth creation. While investing for tax saving, do so in a manner that allows you to remain in sync with your asset allocation, and helps you move closer to your financial needs.

Here are a few key reasons why you should consider a holistic approach and avoid investing just to save tax.

Asset allocation not aligned with financial needs

When you invest in a financial product just for the purpose of tax saving, you may end up with an asset allocation that won’t serve your goals or needs. Consider factors like your financial needs, risk appetite, life stage based requirements, time horizon, etc. to evaluate and devise a financial plan that aligns with your needs. For instance, if you are a young, unmarried salaried individual and want to accumulate wealth to meet needs in the long term like marriage, vacation etc. then your portfolio needs growth assets, investing in interest-bearing income assets only to save taxes will slow down the growth of your corpus. In the long term, the rate of return on growth assets like equity is likely to far exceed that of fixed-income products. That compromise may be expensive.

Inadequate or improper diversification

When saving tax is the sole motive of investment, you have very limited options available which may result in an inadequate or improper diversification of the portfolio. Such inadequacies can reduce the chances of potential gains or expose the portfolio to increased levels of risk as it becomes overly reliant on the performance of a few asset classes. Further, there are millions who still buy insurance policies with high premiums just to save tax. They persuade themselves that it's a smart way to reduce taxes. After a year or two, they discover that the premium is too expensive for them to pay and that stopping the policy will not be beneficial.

A well-diversified portfolio is the foundation of a sound investment strategy. Consider a diversified mix that includes stocks, mutual funds, fixed-income securities, real estate, and alternative investments rather than just concentrating on tax-saving options. By spreading your investments across a variety of asset classes, you can reduce risk and increase your chances of building wealth.

Long-term commitment

Generally, tax-saving instruments come with a long lock-in period, causing constraints on investors. While these instruments offer tax benefits, the inability to access funds when needed can hinder liquidity and limit the investor's ability to respond to changing financial situations or capitalize on emerging opportunities. There are various financial needs that require high liquidity and a short time frame. For example, if you want to save for a down payment on a house in 3 years, you cannot invest in a product with a 5 year lock-in period.

Slow growth

One of the significant drawbacks of having a long-term commitment to tax-saving instruments is the potential for slow growth of corpus. Some government-backed tax-saving investment avenues, such as PPF and NSC, are highly secure instruments, but offer low returns. These products are generally exposed to inflation & re-investment risks. Hence, the growth of investment corpus can be slow as compared to other robust investment instruments.

If your financial needs require you to take high risk and earn high return then investing in just tax saving instruments will not serve the purpose. However, ELSS is a kind of tax saving mutual fund under section 80C of the Income Tax Act, which invests predominantly in equities, hence providing investors with the dual benefit of tax saving and wealth building.

Systematic investments

Rather than just focusing on tax-saving instruments towards the end of the financial year, investors should consider investing on a monthly basis. For instance, if an investor wants to invest in ELSS, then a SIP in ELSS would not only provide tax benefits but also offer greater opportunities for investors to build wealth through equity exposure.

The bottom line

Investment decisions should not be based solely on the motive of saving tax; rather, financial needs and risk appetite should be at the heart of any investment decision. Tax-saving investments are important, but they are only one part of the equation when it comes to financial well-being. A holistic approach considering tax saving instruments along with other asset classes can help build a diversified portfolio that not only aims for wealth accumulation but also seeks to minimize tax liabilities. Every investor is unique, having different financial needs and risk profile, a mutual fund distributor or an investment advisor can guide investors to make the right investment decisions and follow a rational approach to investing.