Financial stress can arise either due to bad investment decisions or unexpected events, personal or economic. One can do very little about the latter, though a larger free cash can assist in sailing though the wave with little or negligible stress.
Investments are made with the object of them being a friend in times of needs. A salaried employee could have invested small amounts in Mutual Fund SIPs, or in accumulating gold over the years of his employment. When the financial crisis hits, the investor should not be swayed away by the tax effects of redeeming the investments. It has become the practice of lenders to induce a fear in the mind of such investors, showing additional the tax cost of withdrawing such investments, vis-à-vis borrowing money from them on the strength of the investment. When the units of Mutual fund or the gold is sold, the gains would of course be taxable.
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On the other hand, if the investment is used as a security to borrow money from the lender, no tax liability arises. But, investors often refuse to see beyond the smoke screen. The stress in which they are, does not permit them to think beyond the short term advantage. A trained mind would recognize that the investments would suffer a tax, either today or 10 years down the line when it is sold. Why not pay the taxes and use the money, rather than being burdened by avoidable interest liability.
The interest paid on the money borrowed is a dead cost to the investor, it adds no value to the investment, nor gives him peace of mind. Infact, the lender drowns into larger stress with the interest burden.
Bad investment decisions can be choosing the wrong asset class for investment, or choosing not to invest when opportunities exist. Financial stress arising due to bad investments largely are short lived – if one follows the policy of not spending good money behind bad money.
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Exiting a bad investment decision can in many times give a small tax break as well. If a newbie investor, without having much idea about stock options, chooses to sell options and records a loss, it would realise the loss and look for opportunities to set off the losses against other taxable income. For taxation purposes, losses may be assets, in so far as they can be carried forward and set off against other taxable income (depending upon the nature of loss, upto 8 years).
Investment decisions should not be driven by short term tax benefits that such investments can extend.
For example, a salaried employee with a short investment horizon, should not look at investment in a public provident fund solely to claim tax deduction against his or her salary income. A tax saver fixed deposit with a 5 year lock in (as against a 15 year lock in for public provident fund would be a better option in such cases. People with higher risk appetite can even choose a tax saver mutual fund, which has a 3 years lock in.
The regulators have built in sufficient safeguards to ensure that the risk of investment in such tax saver mutual funds is minimised, though market related risks do exist.
Though tax cost should be factored in while calculating return on investment, tax should never be the sole criteria for financial planning. Often, seasoned investors advisors caution against seeing insurance products as investment avenues, merely due to tax exemption granted to insurance products. The recent amendments in tax laws have ensured that the elbow room that was available for such investment/ tax planning are significantly minimised.
-The author is Partner, Lakshmikumaran & Sridharan Attorneys. Views expressed are personal.
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