Beware of the yield claims on tax-saving products

 

It’s the tax-saving season and one of the popular tax-saving instruments – the five-year tax-saving bank deposit – is being promoted by banks. A major public sector bank has been prominently advertising its five-year tax-saving deposit, stating yields of 16.64 per cent pre-tax, for regular investors and 17.39 per cent for senior citizens. The rates of interest on these are 8.5 per cent and 9 per cent respectively.

The pre-tax magic

How can an 8.5-percent-a-year interest-generating deposit deliver almost twice the return? Are their claims valid?
Well, they are; only it does not give the full picture. The said advertisement bumps up your returns by considering the tax you save but totally ignores the tax that your interest income will suffer. In other words, it considers the benefit and stops there at a pre-tax stage to make the returns attractive.

Let us take an example to see how this is done: If you invest Rs 10,000 in a five-year deposit that returns 8.5 per cent a year (compounded quarterly) then you will have Rs 15,228 at the end of five years. But remember, in the first year you save taxes to the extent of Rs 3,090 (30% of Rs 10,000 plus 3% cess), if you are in the 30% tax bracket. Therefore your net cash outflow in the year of investment is taken to be Rs 6,910 (10,000-3090).

Lower returns post tax

The effective pre-tax yield is therefore about 17.1 per cent {(15,228/6910)^1/5}. But did you know that the interest of Rs 5228 suffers income tax? Interest income from deposits are treated as ‘income from other sources’ and taxed. So if you are in the 30% tax bracket, you will have a tax burden of Rs 1615, including 3% cess. Net of this, your maturity value is only Rs 13,613 (Rs 15,228-1,615). So the yield comes down to 14.5 per cent.

The return comes down if you are in the lower tax bracket of 10 per cent. Why? Because you enjoy only Rs 1,030 (10% of Rs 10,000 plus cess) as tax saved, instead of Rs 3,090. See table below to know, the actual post tax yields for those in the 10%, 20% and 30% tax bracket.

deposit yield

And remember, if you are a senior citizen, you may well be in the lower tax bracket, which means that your benefits post tax are definitely much lower than what the advertisement claims; although you may receive a slightly higher rate of interest.

Hence, you would do well to take the claims of ‘high yield’ advertisements with a pinch of salt.

The humble NSC

That said, are there any other debt options with similar maturity at this juncture that would provide tax-saving under Section 80C and also deliver good yields post tax? As seen in the table below, both regular investors and senior citizens can earn superior post tax yield if they invest in NSC. This is because, the interest on NSC, although taxable, is treated as reinvested every year under Section 80C and is therefore allowed as deduction. As a result, only the last year’s interest is actually taxed.

nsc yield

In contrast, interest on a bank tax-saving deposit is taxed entirely.

Hence, if you are a tax payer and can take a five-year lock-in, NSC’s current rate (applicable only up to March 2013) is attractive from a post tax perspective.

This article was written by Ms. Vidya Bala, a member of the financial advisory committee at Old is Gold Store.

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