Dummy's guide to stretching paychecks

Wondering how to stretch your paycheck? Let tax-saving instruments do it for you.

You may already be a pro at saving tax and getting more juice out of your salary. But do you know all the nuances of saving tax? If you have just entered the job market only recently or earned your first salary, then you may need this guide for years to come.

Here are the investment options that can help you minimise your tax outgo and stash that little extra away for a rainy day...

A wise man once said: We Indians know how to save money; we just don't know how to invest it right.

While saving your pennies will keep you dry on a rainy day, investing them right is what will help you realise your dreams.

In India, government gives you the option to invest up to Rs 1,00,000 in tax-saving instruments. From financial year 2010-11 onwards, you can save tax on an additional Rs 20,000 by investing in infrastructure bonds. Here are some of the investment avenues that you can use to maximise returns on your savings and save on tax.

Employee provident fund

Employee Provident Fund, or EPF, means a small bit of your salary goes every month into a fund that will feed you in your old age. The scheme covers employees of most public sector and private companies. Your employer also contributes to this fund the amount that is lopped off from your salary. Whatever you pay towards this every month is eligible for tax deduction.

You can also choose to pay an extra amount of your choice if you want to.

Besides tax benefit, you get annual interest at the rate of 8.5 per cent, which is tax-free. You can withdraw the total amount, including interest, when you reach the ripe old age of 55 years.

Other circumstances under which you can withdraw the amount are retirement from work due to disability or health, migration to another country or employment abroad and if you are retrenched from the company.

A good option to build your nest egg.

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The author is co-founder and director of Bangalore-based Perfios Software Solutions Private Limited. www.perfios.com is a personal finance software solution that provides a 360-degree view of your personal finance, with very little manual intervention.

Better known as PPF, Public Provident Fund is perhaps one of the best tax-saving schemes available currently. Safe, assured and tax-free returns make PPF popular.

Under current laws, you can invest between Rs 500 and Rs 70,000 annually in PPF. A government-supported scheme, PPF is safe because the chances of government defaulting on your investments are very low.

PPF gives you tax rebate of 20 per cent.

Currently, the interest earned on the scheme is 8 per cent but government reserves the right to choose how much it will be every financial year. However, your returns work out higher because interest is compounded -- which means interest on interest earned too!

Should bad times befall you, this is one nest egg that will stay safe.

A lesser-known fact about PPF is that if you happen to declare bankruptcy or be sued for loan defaults no one can touch your PPF investments.

Besides, this investment can also help you get secured loans at low interest rates should you need emergency money.

Now, for the downside.

Perhaps the biggest downside of PPF is its long lock-in of 15 years, which makes it ideal for retirement planning but not so good for emergencies.

Of course, you can make partial withdrawals five years after the end of the financial year you started investing in PPF. However, this too is capped at 50 per cent of the account balance at the end of the fourth fiscal year immediately before the year in which you withdraw the amount or at the end of the year before, whichever is lower.

Low interest rates also make PPF not so attractive to risk takers.

As Indians become more stock market savvy, equity-linked savings schemes are fast gaining popularity. Relatively low lock-in period and higher returns make them a good choice for people with high-risk appetite.

By definition, an equity-linked savings scheme is a mutual fund that invests minimum 80 per cent in equities. It may invest the rest 20 per cent in debt and money market instruments, among others.

The lock-in period for ELSS is three years and so, should you wish to you can liquidate your portfolio after this period. Returns vary depending on how the share markets perform. Over the last few years, some of the top schemes have even given returns of up to 30 per cent annually. The returns are exempted from tax.

However, it is important to know that these schemes are vulnerable to the movements in the share markets. So they should be opted for only if your risk appetite is relatively high.

Tax-saving fixed deposits

Tax-saver fixed deposit is a decent option for the risk-averse.

You can invest up to Rs 1,00,000 in these deposits, offered by most banks. The lock-in period is five years and current interest rates are hovering around 7 to 7.25 per cent. Senior citizens get up to 0.5 per cent higher interest.

The interest is usually calculated on a quarterly basis and compounded annually.

While safer than several other investment options, such deposits give relatively low returns as the interest upon maturity is taxable. Besides, the lock-in period is also rather long and the interest rates keep changing depending on the economic environment.

Once you freeze your funds in one of these schemes, the rate at which you get interest will remain constant until maturity, even if the market rates zoom up. Advised only if you are really risk-averse.

Yet another option is the national savings certificate.

While you can invest any amount you want in this tax-saving instrument, you can get income tax rebate only on investment up to Rs 1,00,000 in a financial year.

NSCs are available in different denominations: Rs 100, Rs 500, Rs 1,000, Rs 5,000 and Rs 10,000 in post offices.

The interest rate is 8 per cent a year compounded semi-annually and the lock-in period is six years. NSCs score over tax-saving fixed deposits as their interest rate does not change.

Besides, they are safer and you can transfer them from one post office to another. You can also use them as security for getting loans and transfer these investments to a beneficiary should you wish to.

Now, for the minuses.

Perhaps the biggest minus is that you cannot liquidate your investments in NSCs before the maturity period. Also, the interest that accumulates on your investments and is paid out at maturity will be taxed, but not at source.

You can get tax rebate on the interest earned in first five years if the amount is under Rs 1,00,000. The sixth year onwards, you have to shell out tax on the interest earned. Go for this one only if you have the patience to wait it out.

In a nutshell, unit-linked insurance plans are investment plans offered by insurers that come with a 'dash' of insurance.

On an average, for every Rs 100 invested in a ULIP, Re 1 will go into insurance. From the balance, the agent's commission will be taken out and the rest invested in equities, government securities, corporate bonds and money market instruments, whatever you choose.

Usually, the individual taking the policy has four-six choices while choosing his investment fund, ranging from funds which invest 100 per cent in equity to funds that invest 100 per cent in debt securities.

At any point, you can find out what your investments in ULIPs are worth by finding out its net asset value, which is the value of a single unit of your investment.

In case of ULIPs, the returns on maturity are tax free only if the premium paid annually is lower than 20 per cent of the life insurance cover. Which means, the plan should offer you life insurance cover of at least five times the premium you paid.

The lock-in period for ULIPs was recently increased to five years from three years.

Infrastructure bonds

Starting this financial year, government has added one more instrument to the list of those you can use to save on tax.

You can invest up to Rs 20,000 in long-term infrastructure bonds over and above the Rs 1,00,000 investments allowed for tax savings. The bonds are likely to have maturity period of three to five years and give returns of 6 to 8 per cent.

Advisable because they allow you to save tax on Rs 20,000 more and bring down your taxable income.

Pension plans or retirement plans, offered by life insurance companies, are schemes that help you plan for your twilight years after you have retired from work. There are two kinds of pension plans offered in India -- immediate annuities and deferred annuities.

In case of immediate annuity, the investor will get regular payments from the insurer on a monthly, quarterly, biannual or annual basis, as chosen.

In the case of deferred annuity, the policyholder pays a premium regularly which is invested for a certain number of years after which the policyholder can use the funds to take an immediate annuity from the same insurer or another one.

So deferred annuities are just about building a corpus and then using it to buy a plan that gives you regular pension post retirement.

In the case of deferred annuity, it makes more sense to go for better investment plans that can maximise your returns. Also there's much ambiguity over which deferred annuity plan gives you the best returns.

You can invest up to Rs 1,00,000 into pension plans for saving tax.

Life insurance

Not so much an investment plan but a cushion for your family, life insurance premiums up to Rs 100,000 paid for you, your spouse or children are eligible for tax deduction. All schemes of life insurance up to this amount are considered -- endowment, money back and term plans.

An endowment policy pays back a lump sum at the end of the maturity period. Under this plan, a policyholder gets the accumulated amount after the policy matures or after a certain age. If the policyholder dies before the plan matures, the beneficiary gets the amount promised.

Endowment policy works more as an investment avenue and doubles up as an insurance policy if the policyholder dies. However, you end up paying higher premiums and get lower returns. But the returns are assured, making this plan an attractive one. And they're yours to use however you like.

Money back policy pays the policyholder periodic payments during the term of the policy until he or she is alive.

Unlike in endowment plans where the payout is at the end of the policy term, these pay out funds during the term of the plan.

A big plus of this plan is that should the policyholder die before maturity of the policy term the beneficiary can claim the full sum including the amount that has already been repaid to the policyholder.

While their premiums are rather high, the returns are mostly exempt from tax except under certain situations. What you get is insurance plus investment.

Term policy insures you only during the tenure of the plan. If you outlive the tenure of the term plan, the cover's gone. The advantage is lower premiums.

This is pure insurance and not any kind of investment. These policies have tenures from five to 30 years. Advised if it's only security for your family you are seeking.

You can claim tax deduction on life insurance premiums up to Rs 100,000.

Want to build your dream home? The government wants you to. And so, it gives you Rs 1,50,000 tax deduction every year on the amount you pay as interest towards your home loan. This can lop off a huge chunk from your taxable income and bring you into a lower tax bracket.

You can also claim principal part of the repayment as deduction under the overall Rs 1,00,000 allowed under Section 80C of the Income Tax Act.

While it's silly to buy a home just to save on tax, if you were planning something along those lines, it makes sense to go for it before the government changes its mind and pulls off the benefits.

For now, these can help you grow your profits and save on tax. However, the direct taxes code may just change a lot and many of the abovementioned benefits may go.

We'll keep you posted.