This article talks about one of the most basic ways of saving tax and how to plan the deductions smartly.
How to best use 80C deductions to plan your taxes?
Posted on 05 Jan 2022 • Updated on: 02 Feb 2023
Author: Sayan Sircar
13 mins read
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This article talks about one of the most basic ways of saving tax and how to plan the deductions smartly.
Disclaimer: Taxation is a dynamic concept and the content of this article is valid on the date of publication and any subsequent updates. Always consult a professional tax advisor before doing anything that leads to taxes being due.
📚 Topics covered:
- Principal Component of Home Loan
- Debt investments - short term
- Debt investments - long term
- Equity investments
- 80C waterfall
Section 80C of the Income Tax Act allows a deduction of up to ₹150,000 every financial year (Apr to Mar) for any taxpayer who opts for the “old tax regime”. This deduction means that your tax payable will come down by an amount as per your highest tax rate (plus applicable cess) like this:
- ₹45,000 for 30% bracket
- ₹30,000 for 20% bracket
- ₹15,000 for 10% bracket
You need to add cess to the tax saved, which is currently 4%. So ₹45,000 saving at 30% bracket becomes a saving of ₹46,800.
The deduction is available in two ways:
- eligible investments
- eligible expenses
Many investors approach 80C from the “how to save most tax” angle, resulting in inappropriate investing or spending money to save tax. While the first problem is easy to rectify, the second, which is spending more to save tax, is an unfortunate and permanent loss of capital. For example, do not spend 100 to get 30 back. A deduction that is not suitable for your future financial goals is an effective wastage of 70 of capital since you get 30 back as reduced taxes only after spending that 100.
This article will cover the most efficient ways to claim the deduction so that:
- only appropriate expenses are made
- any tax-saving investment which is made aligns with the investor’s financial goals
The process for 80C investment should happen on the 1st of April and not as a part of a rush from December onwards. Many investors in March 2021 invested in the last week. However, due to a combination of bank holidays and the SEBI rule of unit allocation on the date of realisation of funds, they got their ELSS units allotted in the next financial year.
To claim the deduction:
- preserve all receipts or account statements recording the expense or investment
- salaried taxpayers need to submit copies of the receipts to their employers as a part of the year-end investment declaration process to be included in form 16
- during income tax filing, declare the 80C investments
- investments in eligible schemes can exceed 1.5 lakhs, but the deduction is applicable up to 1.5 lakhs only
The list of 80C deductions below is not comprehensive; however, it covers the most common ones.
Life Insurance Premium
Insurance premium payment is eligible for term insurance and traditional investment plans like whole life or endowment and ULIPs.
Our position on purchasing insurance is:
- buy a term insurance plan for every earning member of the family
- avoid investment plans since they give poor returns
- avoid ULIPs due to high yearly costs, which lead to lower returns relative to mutual funds
Combining a term plan plus mutual fund investments is the better alternative for all investment plans and ULIPs.
Tuition Fee for Children
This provision exists for claiming a deduction for fees paid to a school, college or university as tuition fees (not an admission or other fees) for children.
Principal Component of Home Loan
If you have a home loan, then you can claim the principal component of the EMI under 80C. The home loan issuer will provide an interest certificate that will show the split of principal and interest for that financial year. For deduction purposes, the principal is eligible under 80C and the interest under a separate section called Section 24 (up to 2 lakhs/year). For joint loans, the deduction will be available for both borrowers. E.g. if husband and wife take a joint loan, up to 4 lakhs on interest and up to 3 lakhs on the principal can be deducted. Of course, there are complexities around when the loan was taken vs the status of the house being constructed; still, the overall idea of the deduction is as per the previous sentence.
At this point, it is essential to understand the effect of the tax deduction on principal and interest on the decision to buy a home. The two deductions effectively reduce the interest rate of the home loan. Imagine the EMI is ₹50,000, and the total interest paid is four lakhs, and the principal is ₹ two lakhs. Using the complete Sec 24 and 80C deductions leads to saving ₹60,000 and ₹45,000 less tax payment which can be interpreted as lowering the effective interest paid that year by ₹1.05 lakh (and a little more due to cess being saved), implying a lower interest rate on the loan. If the house is sold within five years, the deduction is reversed.
However, let us look at the purchase of the house holistically. The tax saving is ₹1 lakh/year. A few questions:
- have you identified your goals?
- are you investing enough for your retirement?
- do you think you will be living in that particular house for at least 5 or more years?
At the beginning of the career, a house purchase just for tax-saving may not be the most prudent use of capital. It will be better to check the numbers thoroughly before jumping into a house purchase solely to save tax. After all, the cost of delaying investing for long-term goals is prohibitive: What is the danger of starting investments late?. You should buy a house only if you are confident that you will live in it.
Debt investments - short term
National Savings Certificates (VIIIth Issue) (NSC): This offers 6.8% compounded annually with a cumulative payout on maturity in 5 years. There is no limit on the investment amount, and the maturity amount is taxable.
Five-year tax saving FD
Banks offer a five-year tax saving FD the same as a normal FD, except if you break it before five years, the tax deduction is reversed. Given the tax inefficiency of FDs, investors should carefully evaluate if FDs are right for them. Read more: Mutual Fund vs Fixed Deposit - where should you invest?
Debt investments - long term
Employee share of PF contribution
Salaried employees are eligible for Employee Provident Fund (EPF). The employer and employee both compulsorily invest 12% of the basic plus dearness allowance to EPF every month.
As a financial milestone, once you reach a certain salary bracket, your EPF contribution will exceed the 80C limit, and you will no longer have to submit proof for 80C deduction. The basic salary (plus DA) should exceed ₹12.5 lakhs/year to achieve this milestone.
Public Provident Fund (PPF)
PPF is a very common way to save tax and accumulate a tax-free corpus for long-term goals. The account matures after 15 years and can be extended by five years at a time. The maturity proceeds are tax-free.
A PPF account should be opened by every earning member of the family at the minimum, not for saving tax, but for long term goals. A PPF account requires just ₹500 yearly contributions to remain active. Hence you should open the account as soon as possible to start the 15-year clock. You should invest in PPF only if
- your long term debt goals allow you to invest some amount into PPF. If in doubt, check using the goal-based investing Excel planner
- you do not need the money for 15 years
- you already have enough liquid debt assets (like mutual funds or cash in the bank as FD) to rebalance with equity whenever the stock market falls
If the above conditions are not true, invest only the minimum amount in PPF.
Sukanya Samriddhi Yojana (SSY)
SSY can be opened in the name of a girl child younger than 10 years. The account matures in 21 years and you can withdraw some part of the corpus at the age of 18. Given how the product is structured, the maturity will align more with the child’s PG/PhD period than UG goals. SSY can be maxed out, just like PPF irrespective of the ₹1.5 lakh limit due to the guaranteed tax free return (though the rate varies) depending on the amount available for investing in long term goals. Many families may invest the full ₹1.5 lakhs in multiple PPF and SSY accounts (up to two girl children are allowed SSY to be opened) irrespective of the 80C limit solely for long term goals. The maturity proceeds are tax-free.
However, there are two important considerations for these products:
- Lock-in until maturity: EPF is locked in until retirement, while PPF has a 15-year lock-in (21 years for Sukanya). However, given the general lack of liquidity prevents rebalancing from PF to other assets when the time comes (for example, rebalancing after a 30% fall in equity markets). There need to be sufficient liquid debt assets to rebalance in both directions as per market movements. This is why everyone should not maximise their contribution to PPF and Sukanya without evaluating the asset allocation for retirement
- Falling interest rates: while the interest rate is guaranteed, the recent trend for all of these schemes is downward, requiring you to lower the return expectation from this asset class when building your model. A good practice will be to set the long term debt return expectation the same as the current short term one to build in a margin of safety
Purchase of annuity plans (any deferred annuity or specific annuity plans from LIC/mutual fund) is eligible under 80C as well. Annuities are not suitable for all investors, and it’s need should be carefully evaluated before purchase. Read more: Do you need a pension plan during retirement?
Senior Citizens savings scheme
Investors over the age of 60 are eligible to invest up to ₹ 15 lakhs with a quarterly payout of interest (around 7.4% today) that is taxable. The scheme matures in 5 years, and the investment is eligible for an 80C tax deduction. You must invest within a month of receiving retirement benefits from the employer and is available from the post office and banks.
Equity Linked Savings Scheme (ELSS) funds are mutual funds that are eligible to get tax deductions under Section 80C. However, ELSS funds have a mandatory 3-year lock-in for every purchase. So, if you are investing in SIP form, then keep in mind that every SIP installment is locked for three years from the date of purchase.
Read more: How to choose the best ELSS funds?
NPS Tier 1 contributions are exempt up to ₹1.5 lakhs in 80C (specifically under 80CCD.1). A further ₹50,000 deduction, which is not very useful, is available under Section 80CCD.1B. NPS is a scheme that may not suit everyone due to the lock-in up to age 60. Read more here: What should be my mix of MF, Stocks, Gold, NPS, FD, PPF and ELSS if I want to invest 50k per month?.
Unit Linked Insurance Plans offer insurance and investment in a single product. A part of the yearly contribution is used as a premium for life coverage. The rest is invested in mutual funds after deduction of some additional charges.
ULIPs are notorious for high fees and poor performance vs a simple term insurance policy and a diversified portfolio of mutual funds. Therefore, most Investors will be better off avoiding ULIPs altogether.
We will use a waterfall approach to fill the 80C limit by moving to the next step only if anything is left within the 150,000 limit:
- Step 1: Mandatory EPF contribution if you are salaried (only employee contribution goes to 80C)
- Step 2: Life Insurance premium - Why you should have term insurance?
- Step 3: Housing loan principal
- Step 4: Children’s school tuition fees
- Step 5: Long term investments - NSC, PPF, ELSS, NPS, 5-year tax saving FD etc.
We will move to step 5 only if there is something left after completing the previous steps. At this point, we need to know the asset allocation and SIP amount for all of our goals and choose the most suitable option.
- you can choose NSC/tax saving FD if there is a goal due in exactly five years
- otherwise, choose a mix of PPF/SSY and ELSS for long term goals. The amounts should be as per your monthly SIP amount for all goals
Retired Investors will have a modified waterfall since they will likely not have insurance premiums (do not pay term insurance premium if you do not have income), children’s fees and EPF. Therefore, based on how their retirement portfolio is structured, the appropriate options are SCSS, 5-year FD, ELSS and NSC. This article discusses how retirees can construct a portfolio: How to prepare a retirement portfolio using the bucket approach.
Detailed coverage of taxation for salaried taxpayers is present here:
- How to plan for tax deductions for salaried income?
- Tax planning starts in April and not in December/March: How should you plan your investments and taxes in April?
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