It is the beginning of the calendar year—the time when we think of tax planning with the fiscal year ending in March. Various financial products are sold as tax saving instruments. Tax savings instruments encompass insurance, fixed income and equity. The pressure to invest to save tax is high in the first three months of the calendar year.
The investor and taxpayer should separate from one another. Investments should be made based on outlook for the asset class. The taxpayer should use all tax breaks available to save on tax.
Investments made with tax breaks in mind will almost invariably underperform investments made with future performance analysis. Hence for example if a certain stock is looking to do well in the future but because of pressure to save tax, investment is not made in the stock, the opportunity cost of not making the investment can be very high.
If stock X has been identified as a performer but no investment had been made and the stock rose 100 percent, the opportunity cost of not making the investment is 100 percent.
The tax saving instrument is likely to yield much less and that too depending on various calculations and assumptions. Here the investor would be better off than the taxpayer by making the right investment at the right time.
Save tax by all means by taking life cover or by making that compulsory provident fund investment. However, do not try and save tax by sacrificing a good investment opportunity.
Tax saving can also lead to losses if investments are made at the wrong time to save taxes. Investing in equities at peaks of bubbles in order to save tax is a sure way of losing money. Tax is always paid on gains, which is better than losing capital. Making losses in order to save tax is a criminal waste of capital.
The tax saving theory works when the time comes to exit investments as well. Many investors have actually lost money by postponing profit taking in order to avoid capital gains tax. Investors try and wait for that one year period to get over to sell some investments that are giving profits. However, by the time the one year period is over the once profitable investments would have become to loss-making investments.
Investors should sell investments based on returns, valuations and market conditions. Once target return is achieved, then tax should not come into the picture. If valuations are deemed too high, tax should not be a criterion for selling expensive investments. Bubble-like market conditions should trigger sales rather than trying to save on capital gains tax.
A well researched investment will generate returns so high that tax would not matter and such investments will almost always be held for a much longer period of time than one year. The investors will not have to pay capital gains taxes or will have to just pay long-term capital gain taxes if applicable. On the other hand, a tax saving investment will come with many restrictions and conditions leading to lower returns and illiquidity.
The tax planner and investment advisor should be separated as well. The tax planner has the job of advising on saving taxes and not on making the right investments. The investment advisor has the job of advising on where to invest for best returns and not advising on saving taxes. The expertise for tax planning and investment advise is different and one cannot become both. It is just not possible.
Go ahead and save tax, but not at the cost of not making the right investment.
Arjun Parthasarathy is the editor of www.investorsareidiots.com a web site for investors.