Last Updated on October 8, 2023 at 1:49 pm
You would be surprised as to how many people believe that by investing an additional 50,000 in NPS, they “instantly” get a return equal to their tax slab! This is a case of mis-accounting or innumeracy. In this post, I discuss what exactly is the implication of “saving tax” via investing in 80C and with the National Pension Scheme (NPS).
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Tax Myth 1: Reduction in taxable income is not the same as a reduction in tax payable!
When we say, “Rs. 1.5 Lakh can be invested under 80C for saving tax”, many people interpret this as Rs. 1.5 Lakh of tax can be saved!!
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What this actually means is that out of taxable income in any financial year, Rs. 1.5L can be deducted. This is, by investing Rs. 1.5 Lakh, we reduce our tax liability by 1,50,000 x tax slab(+cess).
If we ignore cesses, and if 12L is the total taxable income, then by investing 1.5L, the taxable income reduced to 10.5L and tax payable is reduced by 1.5L x30% = 45,000
Reduction in taxable income = amount invested.
Reduction in tax payable = amount invested x tax rate
They are not the same!
Tax Myth 2: No Instant returns on tax saving, just more money in hand
Update: kishanm pointed out that I had failed to used the slab configuration of taxation. So I have reworked the numbers below. The main conclusions remain unaffected.
I don’t know how this 30% return (for those in 30% slab) originates! It was so bizarre that I had a hard time arriving at that 30% figure.
Let us continue with the above example.
Taxable income = 15L
Tax to be paid: 2.625L (12,500 in 5% slab + 1L in 20% slab + 1.5L in 30% slab; cess has been ignored uniformly)
Net income at hand: 12.375L
Hang on. I can save some tax.
I make an 80C investment = 1.5L
Then the net taxable income = 13.5L
Tax to be paid = 2.175
Reduction in tax liability: 2.625L —-> 2.175L or 45,000 as mentioned above.
Extra cash in hand: 12.375L + 0.45L = 12.825L (this includes the 1.5L 80C investment)
Before 80C, tax removed (as a percentage of total income): 2.625L/15L = 17.50%
After 80C, tax removed(as a percentage of total income): 2.175L/15L = 14.50% = 2.175/(13.5L + 1.5L)
Notice that the effect of the 1.5L 80C “saving” is already accounted for in the numerator. The calculation ends here! The beenfits ends there!
The problem arises when I claim I got the 45,000 as a return on my investment of 1.5L, or read 45,000/1.5L = 30% “return”.
The correct equation that expresses the benefit is
(2.625L/15L) – (2.175L/15L) = (2.625-2.175)/15 = 0.45/15 = 3%
Tax saved = 3% of total income.
The mistake is using this incorrect equation is (2.625-2.175)/(15-13.5) = .45/1.5 = 30%
This is a case of “double counting”. That is investing 1.5L and saving 45,000 in tax are not independent events. I should use either the reduction in taxable income or reduction in tax for accounting. If I use both, it seems as I have got a return, “instant return” of 30%.
Additional 50,000 “tax saving” with NPS
Now let us “carry on counting” (remember those movies?!) with additional 50,000 investment in NPS.
Note about NPS:
I cannot make my stand more clear than this: Do Not Invest Rs. 50,000 in NPS For Saving Tax!
Trust me, I am a 11Y old NPS investor (not my choice) and it occupies a huge, immovable, ill-liquid chunk in my portfolio. It is a trap.
Stay away from Corporate NPS, if You Wish to Retire ASAP!
Do Not Shift Your EPF Corpus to NPS: It is a Trap!
If you still wish to invest or if you have already invested, try this:
A Guide to investing in the National Pension System (NPS)
Now let us get back to what we were discussing:
Before NPS:
Net taxable income = 13.5L
Tax = 2.175L
After NPS:
Net taxable income = 13L
Tax Paid = 2.025L.
Before NPS, tax removed (as a percentage of net taxable income): 2.175L/13.5L = 16.11%
After NPS, tax removed(as a percentage of net taxable income): 2.025L/13.5L = 15% = 2.025L/(13L + 0.5L)
Here again it is incorrect to claim “30% instant return: because of the 50K invested.
The correct equation to express the benefit is (2.175L/13.5L) – (2.025L/13.5L) = (2.175-2.025)/13.5 = 0.15/13.5 = 1.11%
Tax saved = 1.11% of net taxable income before NPS investment.
The mistake again is double counting: using this incorrect equation
(2.175-2.025)/(13.5L-13L) = .15/0.5 = 30% and claiming an imaginary return.
Do not confuse more capital to invest (with conditions) as more returns!
1.5L in 80C + 50K in NPS
We started with 15L income and because of an investment of 2L (1.5L + 0.5L), the tax liability has come to 2.025L.
That is, from the 2.625L tax it has reduced to 2.025L. A reduction of 22.86%.
Now, before any tax saving investment, tax/income = 2.625L/15L = 17.5%
After tax saving investment, tax/income = 2.025L/15L = 13.5%.
A change of 4%
Summary
You do not get any “returns” for reducing your tax outgo. All you get is more money at hand (including the tax saving investment made).
Extra capital to invest should not be confused with extra returns!!
Where you invest that extra money is more important!!
Here is another innumeracy: Can you really save tax with a home loan?!
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