Benefits of sequencing tax deductions

You must have made all kind of investments for your tax planning.

For this you may have invested your money in a number of avenues like the Employees' Provident Fund (EPF), Public Provident Fund (PPF), Unit Linked Insurance Plan (ULIP), National Savings Certificate (NSC), bank fixed deposits (FDs) and equity Linked Saving Scheme (ELSS).

And all this to claim tax deductions available under Section 80C and Section 80CCC.

But do you know that most of the investment avenues like EPF, PPF, ULIP, NSC, ELSS and bank FDs differ in risks, quantum of returns, taxability of the returns, variability of returns (discussed in Risky markets? Safe investment avenues) and revocability of tax deduction.

Understanding revocability and irrevocability of tax deductions and prioritising their sequence will not only help you streamline your investments but also plan for efficient tax saving.

What are irrevocable and revocable deductions?

Tax deductions under section 80C are generally given on long-term investments. Most tax savings investments have a lock-in period, which makes sure that the investments are for long term. Lock-in refers to a minimum time period before which you cannot withdraw the amount invested. 

For example, PPF is 15-year account, NSC is locked in for 6 years, bank FDs are for 5 years and ELSS are locked in for 3 years. Tax deductions claimed on these investments cannot be taken back. So these become irrevocable deductions.

For some other investments such as house property and insurance policies there is no lock-in period. You can sell your home any time you want to and surrender/cancel your insurance plans whenever you wish to do so.

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For these investments the income tax law indirectly provides for a lock-in period. For house property it is set at 5 years while for insurance policies it is 2 years.

So if you sell your house before 5 years or discontinue your insurance policy before 2 years the tax deductions claimed on the same in the earlier years are added to the taxable income of the year in which house property is sold or insurance policy is cancelled/ discontinued.

Thus, deductions under section 80C on house property and insurance are revocable. That is, they can be taken back.

While some deductions are revocable in nature some are irrevocable. From the list of investment and tax saving options that we discussed yesterday (discussed in Risky markets? Safe investment avenues) EPF, PPF, NSC, bank FDs, ELSS and your child's tuition fees are irrevocable and payment of stamp duty and registration fees and repayment of home loans are revocable under certain conditions.

These conditions are:

Suppose you have taken a home loan from a bank at 10% floating rate of interest. If some other bank offers you a loan at 9% floating rate of interest and you switch to this loan then you have refinanced your home loan.

Deduction is also not available if the construction of the property is not completed before the last day of the financial year. If you want to avail of tax deduction on any property this financial year (2007) then you need to complete work on it before March 31, 2007.

An important point is this is a revocable deduction. If the property is sold within 5 years from the end of the financial year in which it was purchased then all the deductions claimed under section 80C in respect of that property are added to the taxable income of the assessee in the year of sale.

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This is a revocable deduction. If the property is sold within 5 years from the end of the financial year in which it was purchased then all the deductions claimed under section 80C in respect of that property are added to the taxable income of the assessee in the year of sale.

The deduction is revoked if the policy is terminated before paying premiums for at least two years. In case of single premium policies, the deduction is revoked if the policy is cancelled before 2 years from the date of commencement of insurance.

Hence it is important to set a priority on your investments while claiming tax deductions.

Priority sequence for claiming tax deduction

As we have seen in above instances, some deductions are revocable, i.e. can be taken back in later years and some others are irrevocable. Therefore prioritizing the deductions would help plan your taxes more efficiently.

Let's take an example. Your taxable salary is Rs 4,00,000. Your investment under section 80C is as follows:

Contribution to EPF: Rs 20,000

Housing loan repayment (house was purchased in the current year): Rs 30,000

Stamp duty and registration fees for the above house: Rs 60,000

Children tuition fees: Rs 10,000

Contribution to PPF: Rs 30,000

Life insurance premium paid (for 3rd year): Rs 10,000

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EPF and PPF contributions and children tuition fees are irrevocable deductions. Therefore, they should be claimed first. Since the insurance premium is paid for the 3rd year that also becomes an irrevocable deduction. Therefore, total irrevocable deduction is Rs 70,000.

Tax deduction on repayment of home loan or on payment of stamp duty/registration fees are revoked if the house is sold within 5 years from end of the year in which property is acquired or constructed. Hence tax deduction on the same should be claimed only for the balance amount i.e. Rs 30,000 (Rs 100,000 – Rs 70,000).

However, if you were very likely to sell the house within 5 years then it would be a good idea not to claim for tax deduction on repayment and stamp duty/registration fees at all and invest the balance Rs 30,000 (Rs 100,000 – Rs 70,000) in some other avenue.

ADROIT is a Pune-based firm that specialises in providing tax and investment services to individuals including non-residents. They can be reached at tax@adroitservices.in