Tax efficiency of a financial decision is the degree to which tax burden is reduced vis-à-vis the alternative structures, aiming for the same outcome. It is indicative of potential of savings by prudent choice of investing option & is as significant to ‘return on investment’ & ‘wealth creation’ as the investment selection & asset allocation are.

Income tax is a cost, directly attributable to an investment. This drag on return can be reduced by choosing a mode of investment that invites least income-tax incidence, while maximizing the return potential. It is the ‘post-tax-return’ that is relevant for the investor. A reduction in the income-tax cost, naturally improves the net rate of return for the investor & increases the pace of compounding of wealth creation.

• Tax saving of Rs. 1 lakh each year over working life of 30 years equals ‘Total Savings’ of Rs. 30 lakhs.
• If these annual savings earn CAGR of 10%, it transforms into additional wealth of Rs. 1.65 Cr.

Investment & Income Tax

Income-tax rules are often used to provide incentive for capital formation in certain areas of economy & hence certain savings are either exempted or treated to lesser income-tax burden. The incentives are implicit in the mode of investment & the rules relating to what constitutes taxable income.

Each investment goes through 3 stages – (1) Investment, (2) Earnings (capital appreciation / return paid out or reinvested) & (3) Maturity / Redemption / Withdrawal. The income-tax rules specify the method of calculation & the stages that are exposed to income-tax.

6 Variations in Tax Treatment

Three stages make for six possible ways in which an investment could be either be exempted (E) or taxed (T). The difference in tax treatment arises due to

• classification of investment as an asset or loan,
• revenue recognition rules &/or
• need to channelize public savings towards certain instruments.

EEE – Exempt, Exempt, Exempt

• Tax deductions at the time of investment,
• Tax Exemption to income earned on investment &
• No Tax at maturity / redemption stage.

Examples of such least taxation are –

• Employee Provident Fund (EPF) – Deduction under Sec 80C, Exemption of TDS on interest for contribution under Rs. 2.5 lakhs/5 lakhs, No tax on maturity
• Public Provident Fund (PPF) – Deduction under Sec 80C, Exemption on interest for annual contribution under 5 lakhs, No tax on maturity
• Sukanya Samriddhi Yojana – Deduction under Sec 80C, Exemption on interest, No tax on maturity

• Life Insurance Policy – Deduction under Sec 80C, Exemption on interest, No tax on maturity
• Unit Linked Insurance Plan (ULIP) – Deduction under Sec 80C, Exemption on interest, No tax on maturity

EET – Exempt, Exempt, Tax

• Tax deductions at the time of investment,
• Tax Exemption to income earned on investment &
• Tax Deferred till time of withdrawal.

Examples of such deferred taxation are –

• Pension Plans incl. NPS, Unit Linked Pension Plan (ULPP) – Deduction under Sec 80C, Exemption on capital appreciation, Tax on annual pension received from non-commuted portion & on surrender value
• Equity Linked Saving Scheme (ELSS) – Deduction under Sec 80C, Exemption on capital appreciation, Tax on long term capital gain on units redeemed in excess of Rs. 1 lakh

ETE – Exempt, Tax, Exempt

• Tax deductions at the time of investment,
• Tax on income accrued/received on investment &
• No Tax at maturity / redemption stage.

Examples are –

• 5-Year Tax Saving Fixed Deposit – Deduction under Sec 80C, Tax on interest earned, No Tax on maturity
• National Savings Certificate (NSC) – Deduction under Sec 80C incl. interest reinvested for first 4 years, Tax on interest earned, No Tax on maturity
• Senior Citizen Savings Scheme – Deduction under Sec 80C, Tax on interest earned (interest up to Rs. 50,000 exempt under Sec 80TTB), No Tax on maturity

TEE – Tax, Exempt, Exempt

• No Tax Deductions at the time of investment,
• Tax Exemption on income earned on investment &
• No Tax if held to maturity. 

Example is –

• Tax Free Bond – No tax deduction on investment, Tax exemption on interest earned (interest rate payable is lower than prevalent market rate), No Tax if held to maturity (capital gain tax if sold earlier)

TET – Tax, Exempt, Tax

• No Tax Deductions at the time of investment,
• Tax Exemption on earnings on investment as long as not redeemed / matured &
• Tax on earnings in year of redemption / maturity

Examples are –

• Debt & Debt Oriented Hybrid Mutual Fund – Tax on Capital gain on units redeemed at marginal tax rate, if redeemed before 3 years & after 3 years @ 20% on capital gains after cost inflation indexation
• Equity Shares & Equity Oriented Mutual Fund (Except ELSS) – Tax on Capital Gain on units redeemed @15%, if redeemed before 1 year & after 1 year @ 10% (in excess of Rs. 1 Lakh)
• Fixed Maturity & Monthly Income Plan Mutual Fund

TTE – Tax, Tax, Exempt

• No Tax Deductions at the time of investment,
• Tax on earning &
• No Tax on redemption / maturity

Examples of such maximum taxation are –

• Fixed Deposit (FD) with Bank / Corporate – Accrued Interest taxed at marginal tax rate
• Recurring Deposit (RD) – Accrued Interest taxed at marginal tax rate
• Post Office Monthly Income Scheme – Accrued Interest taxed at marginal tax rate

Tax Planning through Mutual Funds

Tax Planning is analyzing a financial situation from tax perspective so that financial goals could be achieved with minimum tax burden. Mutual Funds are on top of the tax efficiency scale on account of its classification as a ‘Capital Asset’, favorable taxation rates, operative flexibility & liquidity.

• The return on mutual fund investment is recognized as Capital Gain (as opposed to Revenue Income) & that makes the distinction between realized & unrealized return, quite significant from taxation perspective. Only the realized gain i.e., profit in respect of ‘investment-sold-during-the-year’, is taxed. Unrealized gain is just paper profit that is not required to be reported in the annual income tax return.

• Taxation rules for a mutual fund remain unchanged even if the underlying investment is earning revenue income. Profit on sale of scheme earning interest on debt instruments, is still a capital gain & is amenable to postponement & reduction of tax on incomes that would otherwise be taxed at marginal tax rate. For example, interest income on FD, RD & loan is taxed at marginal tax rate (on accrual, not receipt basis) but the same income, housed in a mutual fund scheme, can remain untaxed till the time of sale of such scheme. Also, the said sale of mutual fund scheme can be spread over various financial years to reduce / spread income-tax burden.

• No TDS (tax is deducted at source) is deducted on mutual funds except to NRI.

• A mutual fund scheme itself, is not subjected to income tax because the said income belongs to the investors. However, the same realized gain would be taxed if the transactions were done in investor’s personal capacity. Thus, routing an investment through a mutual fund scheme helps avoid recurring tax cost on income that gets realized due to compulsions of portfolio management or expiry of individual investments. The obvious benefit is improvement in rate of return on investment.

• Capital Gains are taxed more favorably as compared to other revenue incomes, by the government to promote economic activity in the country. Lower tax rate applicable to capital gains as well as concept of cost-inflation indexation, leads to significant reduction in tax burden.

• Carry Forward & Set-Off rules for Capital Loss incurred during the year, also help reduce / plan income-tax outgo.

• Investment in mutual funds is not charged to wealth tax.

• Clubbing provisions of Sec 64 of Income Tax Act (income of minor & income on gift to spouse, daughter-in-law) can be overcome if investment is done via mutual fund. The flexibility of timing the sale & non-taxation on unrealized income enables better tax planning.

Tax Efficiency of Indexation

The Income Tax Department allows adjusting the cost of purchase for inflation at the time of sale of House Property & ‘Other than Equity Oriented Mutual Funds’ (after holding period of 2 & 3 years respectively). Adjusting the purchase price for inflation is called indexation & helps reduce the tax burden.

Indexed cost = (Index for the year of sale/ Index in the year of acquisition) x cost.

Cost Inflation Index
Sno.	Financial Year	Cost Inflation Index
1	2001-02	100
2	2002-03	105
3	2003-04	109
4	2004-05	113
5	2005-06	117
6	2006-07	122
7	2007-08	129
8	2008-09	137
9	2009-10	148
10	2010-11	167
11	2011-12	184
12	2012-13	200
13	2013-14	220
14	2014-15	240
15	2015-16	254
16	2016-17	264
17	2017-18	272
18	2018-19	280
19	2019-20	289
20	2020-21	301
21	2021-22	317
22	2022-23	331

Illustration –

Purchase Cost = Rs. 1,00,000/- in financial year 2005-06,

Sale Value = Rs. 4,50,000/- in financial year 2022-23

(A) Without Indexation

Financial Capital Gain = 4,50,000 – 1,00,000 = Rs. 3,50,000/-

Income Tax @ 20% = Rs. 70,000/-

Post-Tax Capital Gain = 4,50,000 – 1,00,000 – 70,000 = Rs. 2,80,000/-

(B) With Indexation

Indexed Cost = (331/117)*1,00,000 = Rs. 2,82,906/-,

Taxable Capital Gain = 4,50,000 – 2,82,906 = Rs. 1,67,094/-

Income Tax @ 20% = Rs. 33,419/-

Post-Tax Capital Gain = 4,50,000 – 1,00,000 – 33,419 = Rs. 3,16,581/-

Tax Efficiency due to Indexation = 70,000 – 33,419 = Rs. 36,581/-

Superior Compounding

Debt Mutual Fund vs. Bank Fixed Deposit

Interest accrued on bank fixed deposit is taxed at marginal tax rate while the same income if routed through mutual fund instrument, could fall outside the tax net. The tax saved or rather not paid, remains part of the principal amount & earns return as well. The following years witnesses the return on ‘tax-not-paid’ continuing to earn ‘return-on-return’. As it happens with compounding, the benefits grow exponentially with passage of time.

Year    FIXED DEPOSIT @ 6% CAGR                  DEBT MF @ 6% CAGR

Opening Balance (Rs)

Return @ 6% p.a.

Tax @ 30.90%

Post Tax Return (Rs.)

Closing Balance (Rs)

Opening Balance (Rs)

Return @ 6% p.a.

Closing Balance (Rs)

1	100,000	6,000	1,854	4,146	104,146	100,000	6,000	106,000
2	104,146	6,249	1,931	4,318	108,464	106,000	6,360	112,360
3	108,464	6,508	2,011	4,497	112,961	112,360	6,742	119,102
4	112,961	6,778	2,094	4,683	117,644	119,102	7,146	126,248
5	117,644	7,059	2,181	4,878	122,522	126,248	7,575	133,823
6	122,522	7,351	2,272	5,080	127,601	133,823	8,029	141,852
7	127,601	7,656	2,366	5,290	132,892	141,852	8,511	150,363
8	132,892	7,974	2,464	5,510	138,401	150,363	9,022	159,385
9	138,401	8,304	2,566	5,738	144,140	159,385	9,563	168,948
10	144,140	2,672	2,672	5,976	150,116	168,948	10,137	179,085
11	150,116	9,007	2,783	6,224	156,339	179,085	10,745	189,830
12	156,339	9,380	2,899	6,482	162,821	189,830	11,390	201,220
13	162,821	9,769	3,019	6,751	169,572	201,220	12,073	213,293
14	169,572	10,174	3,144	7,030	176,602	213,293	12,798	226,090
15	176,602	10,596	3,274	7,322	183,924	226,090	13,565	239,656
16	183,924	11,035	3,410	7,625	191,550	239,656	14,379	254,035
17	191,550	11,493	3,551	7,942	199,491	254,035	15,242	269,277
18	199,491	11,969	3,699	8,271	207,762	269,277	16,157	285,434
19	207,762	12,466	3,852	8,614	216,376	285,434	17,126	302,560
20	216,376	12,983	4,012	8,971	225,347	302,560	18,154	320,714

Total (Rs.)

56,052

225,347

320,714

Corpus accumulated after 20 years >>>

FD = Rs. 2,25,347/-

Debt Mutual Fund = Rs. 3,20,714/-

Excess Return (Debt MF over FD) on Rs. 1 lakh over 20 years (Rs.)

95,366

Tax Efficiency at Highest Tax Bracket on Rs. 1 lakh over 20 years (Rs.)

56,052