What is Section 80C?

The government, in order to encourage savings, gives tax breaks to certain financial products as discussed in Section 80C of the Income Tax Act. These investments are often referred to as 80C investments.

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Up to a limit of Rs 1 lakh, the money that you invest in these products is deductible which means that you don't have to pay income tax on it. Thus if you are in the 30 per cent tax bracket and you invest the maximum allowed you save Rs 30,000 in taxes.

There are a wide range of investments you can make to claim the Section 80C benefit. To keep things simple we will focus on two categories: Small savings schemes and ELSS (equity linked savings schemes). Other 80C products include your provident fund, the repayment of principal on your home loan and your life insurance premium.

Small savings schemes

These include the public provident fund (PPF) and National Savings Certificate (NSC). They offer a return of around 8 to 8.5 per cent which is quite low compared to typical returns in equity products. Furthermore, there is a relatively long lock-in period, 15 years for the PPF and 6 years for the NSC. Their main advantage is that they offer a guaranteed return unlike equity-based products.

Equity linked savings schemes

These are basically mutual funds which are specially created to provide tax benefits. As with regular mutual funds there is no guaranteed return and you can lose money in a period of falling stock prices as has happened in the first half of 2008. However, ELSS usually provides a higher return than small savings schemes and also a lower lock-in period of three years.

Examples of ELSS include Franklin India Taxshield and HDFC [Get Quote] Taxsaver. As with regular mutual funds, these schemes pursue a range of investment strategies: For instance, some may focus on large cap stocks while others may focus on small and mid cap stocks. It makes sense to invest in more than one scheme to diversify some of your risk.

Making a choice

How do you decide to allocate your Rs 1 lakh 80C limit? This will depend on your other financial decisions; for example whether you have taken a home loan or purchased life insurance. As to the decision between small savings schemes and ELSS two of the most important factors are your attitude to risk and inflation.

As recent months have shown so clearly, stock markets are a lot riskier than small savings schemes. However, the flip side is that riskier investments like stocks offer a higher rate of return particularly over the long run. From the perspective of a young investor who may not need most of her/his investment money till retirement it probably makes sense to tilt towards riskier assets.

The other important consideration when evaluating returns is to adjust for inflation.

In other words, if your investment generates a return of 8 per cent and inflation is 7 per cent, then your inflation-adjusted return is only one per cent. When inflation moves into double digits you are actually making a negative inflation-adjusted return, as is happening currently. This is a fundamental problem with any investment product that offers a fixed return at a time of high and rising inflation.

By contrast stocks are a better hedge against inflation especially in the long run. Though inflation increases the costs of firms it also allows them to charge a higher price to their customers thereby protecting profits to some extent. This in turn means that stock prices and equity-based products can offer better protection from inflation over a number of years though not necessarily in the short run.

What about the element of timing when it comes to equity schemes? For instance, stocks have clearly taken a pounding in the last six months. However this doesn't necessarily mean it's a bad time to invest in stocks; valuations in some companies look quite attractive now and over a three-year horizon you could see decent returns.

From the point of view of the average investor it's probably best to take timing out of the picture by following a systematic investment plan which means you invest a fixed amount every month.

Small savings schemes and ELSS each have their advantages and disadvantages. Based on your investment strategy and particularly your attitude towards risk you have to choose how much to invest in them as part of your Section 80C investments.