Interestingly, if you have a taken a housing loan then even if your salary income exceeds Rs 1.5 lakh or Rs 5 lakh, you are eligible for tax rebates. This is because interest on housing loan can bring down your income below the threshold level. In other words, the tax benefits associated with housing loans have increased with this budget. So, the best form of tax planning is now a housing loan.

Otherwise, the tax planning requirements are simple. Do not get into an annual commitment. This is because tax policy may change next year. It does appear that the government favours reducing the number of tax rebates given to investors.

So, if tax policy changes next year, then investment in a different investment product may be more suitable to achieve your investment goals.

In addition, favour tax-free investments such as single premium insurance plans. Returns from such instruments are quite attractive.

Even in the case of pension plans (investments in pension plans can be reduced from income but are taxable in the year of withdrawal), it may be better to stock to single-premium plans.

Importantly, the returns from a tax saving investment continue to be significantly attractive. So, don't abandon tax saving investments. They should continue to be an integral part of your investment plans.

Fixed income investments

A significant change with respect to fixed income investments relate to taxation of dividend income from mutual funds and interest income from deep discount bonds. With dividend income from mutual funds no longer exempt from tax, it may be appropriate to shift to growth option of mutual fund debt schemes. Redeeming units from these schemes when you have held the units for a year is the most tax-efficient way to generate income.

Given that mutual fund debt schemes no longer enjoy tax incentives, should investors revert to direct investing totally to generate better after-tax returns? The answer is no. For most investors, the total return from an investment will still be higher if you remain invested in mutual funds.

This is because re-investing income from investments, which is essential to generate a decent return, is a difficult issue for most individual investors. Investors may either lack skill or the amounts may be small rendering re-investment difficult. So, stick to mutual fund debt schemes for now to generate income and maintain liquidity.

For long-term investments, consider direct investing in government securities, insurance schemes, RBI Relief Bonds and similar attractive options. Specifically, seek exposure to corporate bonds — which are usually of short-term and medium-term nature — through mutual funds.

As regards deep discount bonds, you will have to offer income for tax every year now compared to paying tax in the year of maturity earlier. This is not applicable to investors who hold deep discount bonds with a face value of Rs 1 lakh or below. Such investors can continue to offer income for tax in the year of maturity of the deep discount bonds.

So, do not invest more than Rs 1 lakh in deep discount bonds. That can reduce the returns from your investment considerably. Unfortunately, it is applicable to all your existing holdings. That is, the change is applicable with retrospective effect. If you have already invested more than Rs 1 lakh in deep discount bonds then you may have to pay tax on income that you will receive only at the maturity of the bonds. You have no choice.

Taxes and equity

India had probably one of the most investor-friendly taxation regimes till February 2002. The removal of exemption for dividends has however increased the tax incidence on returns from an investment in equity. The enhanced tax incidence on dividends has the potential to reduce sharply the returns from dividend paying stocks.

If you expect gains from a stock only in the form of dividends than you may have to adjust your plans accordingly. For example, if you chose stock A with a dividend yield of 10 per cent over stock B which would have given a capital gains of nine per cent then it may now be time to shift to stock B. In other words, changes in dividend taxation have implications for the stocks in your portfolio.

Otherwise, tax rates for long-term capital gains at 10 per cent continue to be much lower than the maximum marginal rate of 30 per cent at which short-term capital gains are taxed. Since capital gains are more important than dividends, the nature of tax planning required in this case is quite clear-cut and simple — reduce the proportion of short-term capital gains and increase long-term capital gains.

To achieve this is not so simple an exercise, though. If you hold on to a stock for a year in order to reduce taxes, you run the risk of losing if the price of the stock falls. Besides, holding on to a stock that has appreciated in value also increases the weight of that particular stock in your portfolio to an undesirably high level. But there is hardly a choice in this area. Investors have to make a trade-off here — pay higher taxes or run the risk of a decline in value. In most cases, paying higher taxes may be the only alternative. But the larger question that remains is whether individual investors should invest directly in stocks or through mutual funds.

In the case of equity investing, it is difficult to reduce the proportion of short-term capital gains. Consequently, when you invest directly, you will have to pay considerable taxes on short-term capital gains. In contrast, when a mutual fund derives short-term capital gains, you do not have to pay higher taxes.

This will be the case if you hold the units for more than a year. Of course, you will pay tax at 30 per cent on dividends distributed. But this can be avoided by choosing the growth option.

So growth option of mutual funds may be the most tax-efficient option for investing in equity for most investors. If you choose investing directly, then your ability to derive gains should be that much better than that of a typical fund manager that it offsets the higher capital gains tax. Since that is highly unlikely, stick to mutual funds.

However, this assumes that you plan to pay taxes. If you don't plan to pay taxes, feel free to strike out on your own.

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