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For most individuals, Section 80C of the Income-Tax Act is the primary means for saving taxes. Individuals typically avail benefits under Section 80C by investing in provident fund (PF), public provident fund (PPF) and equity-linked savings scheme (ELSS). Previously in this column, we discussed why investing in PPF and PF is more optimal than investing in ELSS. In this article, we discuss how to structure your investment in PPF.
Compounding returns
There are two advantages associated with PPF investment. One, interest earned on the investment is exempt from tax. Second, interest is compounded, but the investment does not eliminate reinvestment risk. This is the risk you will be forced to reinvest annual interest at a lower rate if interest rate declines.
Bank deposits
Take bank recurring deposit and cumulative fixed deposit. The interest prevailing at the time of initiating the deposit is locked-in through the life of the deposit. So, these two kinds of deposit eliminate reinvestment risk. Interest rate on PPF is reset quarterly.
So, PPF investment will earn lower return if interest rate declines, exposing you to reinvestment risk. The comforting factor is you do not have to look for avenues to reinvest. The accrued interest is automatically reinvested into your PPF account.
Overarching argument
That interest income is tax-exempt is the overarching argument to consider PPF investment. Note, your interest income is otherwise taxable at your marginal tax rate (30 per cent). So, you save ₹45,000 if you invest ₹1.5 lakh every year. Also, note you can renew PPF account each time for a block of five years after its initial maturity period of 15 years. So, it may be optimal to renew the account till you retire, as PPF can be an important part of your retirement portfolio.
Conclusion
You should consider investing ₹1.5 lakh annually, regardless of the headroom you have under Section 80C. That is, exhaust the PPF limit of ₹1.5 lakh without considering other eligible investments your make under the section. Your tax deduction will be limited to ₹1.5 lakh.
The argument is simple. You can avail the tax benefit if you invest in ELSS. But, you will be unable to shield income on your bond (read interest earning) investments from taxes unless you invest under Section 80C in PPF and PF. To avail the benefit of compounding, it is preferable to invest lump sum or large sums in PPF earlier in a financial year than later.
(The author offers training programmes for individuals to manage their personal investments)
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