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Tax Saving vs Tax Free- Know the Difference
March 02 , 2013

Financial year end is round the corner and from the last 2 months many people are frantically trying to make up for whatever gaps are remaining in making their hard-earned money less taxable for the year. We have had queries pouring in on best investments for 80C, what other savings options are there besides 80C, EPF, PPF vs NSC and also a lot of queries on whether 80CCF benefit is still available for the current tide of tax free bonds in market.

One common mistake we observed was that in many people's mind tax saving instruments and tax free instruments are one and the same. Some have ended up buying tax free bonds thinking it would give them tax savings. In this article we will shed light on tax saving investment and tax free investments and which instruments to choose for them.

Tax saving investments

When you invest for tax saving your income tax liability is reduced by the amount of investment subject to maximum limit allowed by Income Tax laws governing that investment. From your taxable income you get to deduct the amount of investment and thus lower your tax liability.

For instance suppose your gross total income is Rs 5 lakhs. You put Rs 75,000 in all in various tax saving investments. That makes your taxable income Rs 4.25 lakhs- you need to pay income tax on only so much amount.

Thus tax saving investments give you scope for income tax deductions. We'll cover what sort of investments are there presently of tax saving nature. You'd find that majority of your investments are of tax savings type and not tax free type.

Tax free investments

Tax free investments give you streams of income that is not taxable at all. In other words tax free investments have income tax exemption. Tax free investments do not give you any rebate for the amount you invest in them but whatever income you derive out of them will be out of the income tax net.

Again assume your income from salary is Rs 5 lakhs and you have income of another Rs 50,000 from tax free investment. This Rs 50,000 is not to be added to your taxable income. It is exempt from income tax. Options for tax free investments are not popular since they are few.

Tax saving investment options

All those equity and debt products that allow you to deduct the investment amount from your total income are tax saving in nature. You would recollect that most of these are under section 80C and so you have ELSS, NSC, tax saving FD, SCSS, etc for tax saving instruments.

But tax saving is not limited to these investments; certain expenses also have tax savings status. Expenses like life insurance (blame it on mis-selling you might want to classify it too as an investment), principal repayment of home loan, tution fee of children, health insurance premium, education loan interest, etc has income tax deduction and so is tax saving.

RGESS is also a tax saving option.

Tax free investment options

All we can think of is tax free bonds from infrastructure companies. Many of these are open for subscription now. The interest on tax free bonds is tax free.

Tax free bonds are unattractive to common tax payers because the interest they pay is fixed for a long tenure and is at times lower than bank FDs. Liquidity of tax free bonds is also a major concern. To repeat a common assumption for clarification- these are not 80CCF bonds for tax saving. These bonds may be considered by retirees and those approaching retirement in order to have streams of income that falls out of income tax net.

How about tax saving + tax free investment?

Some of the 80C tax saving options mentioned above also tax free in nature. ULIP is an example. Apart from income tax deduction on the premiums whatever payout you earn from it is also tax exempt.

Similarly ELSS and RGESS have dual benefits. Both the investment and returns are tax free. However if you choose dividend option the returns cannot be said to be tax free although dividend tax liability is not on you. The mutual fund would pay out lesser return in dividend option of funds.

PPF also has both tax saving and tax fee benefits. Both the annual contribution and interest have income tax rebate. Similarly in EPF the employer's contribution of up to 12% of basic salary is exempted from income tax while your contribution up to Rs 1 lakh can get tax deduction under section 80C. Payouts from PF is also tax-free.

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