Budget 2005-06 has been a bonanza for individual tax payers. Or so everyone thinks. The increase in the income tax exemption limit has ensured that people across tax brackets pay lesser taxes (baring some specific cases where the tax incidence will be marginally higher).

By consolidating the individual tax rebate and deduction schemes under the new section 80C with a overall limit of Rs 1,00,000 - without any sub-limits on the amount of individual investments - P Chidambaram has essentially given people the freedom to plan their taxes in a way that enables better financial planning.

While you make investments to minimise your tax outgo, you can now formulate an investment portfolio consisting of debt, equity, mutual funds and real estate while providing for life and medical insurance, too.

Besides, you can claim deduction for expenses like your children's education (well, only tuition) and principal repayment on housing loans. That is the good news.

And, now, the bad news. The worst part of the deal is that the finance minister will ensure in the future that every penny that you earn is taxed.

If not today, then tomorrow. How? Currently, there is considerable variation in the taxation of the money invested in savings schemes, the tax levied on accumulations or the return earned thereon, and the tax treatment at the final stage of withdrawal. The idea is to ensure that the money you earn either by way of salary or through your investments gets taxed eventually.

This will happen under what is called the EET (exempt exempt taxed) scheme, wherein the contributions to specified savings is exempt from tax (E), the accumulation is also exempt (E) but the withdrawals/benefits from savings are taxed (T).

Given this background, we compare various investment options across asset classes and suggest strategies to maximise your tax benefits without compromising on your financial goals.

The window of opportunity
Doing away with section 80L, which entailed tax exemptions for annual interest upto Rs 12,000 and an additional Rs 3,000 for income earned on government bonds, means that the return you earn on certain savings instruments is now taxable.

So income from all post-office savings schemes and other government bonds is fully taxable. The only exception to this rule is the public provident fund (PPF), where the interest earned is not taxable.

Experts feel that in the transition to the EET regime, this exceptional benefit for PPF will be done away with for all new commitments to PPF. This announcement is expected to come in as early as April 1, 2005.

It is important to note here that the death and survival benefits on insurance plans are also exempt from tax in the hands of the policyholder, but it may not be a wise idea to hike your contribution to insurance unless you really require it.

Also, insurance investment schemes do not compare favourably with investments in mutual funds or equities due to lack of transparency and front-loading of expenses.

Key takeaway: There is a one-month window of opportunity between now and April 2005 to earn a tax-free return on PPF.

Since the amendment to the PPF scheme in order to make it EET-compliant is yet to be worked out, one can utilise this opportunity and pump in money into a PPF account. So those who have not already exhausted their deposit limits should now prefer PPF over other small-savings instruments.

The more efficient fixed deposits
The elimination of section 80L also means that income from bank deposits, RBI (taxable) bonds and infrastructure bonds are now fully taxable. Mutual funds now look more attractive based on tax-adjusted returns.

Currently, debt-based mutual funds are required to pay an effective dividend distribution tax of 14.025 per cent (including the 10 per cent surcharge and 2 per cent cess). This income is tax-free in the hands of the investor. What about capital gains?

Units sold within one year qualify as short-term capital gains and are subject to tax at the marginal income-tax rate. Units sold after one-year attract long-term capital gains of 20 per cent plus a surcharge of 10 per cent and 2 per cent cess after availing of indexation benefits or a flat 10 per cent plus a surcharge of 10 per cent and 2 per cent cess.

Indexation is a relief provided by adjusting the return on which tax is calculated downward, to allow for reduced buying power of the saved amount due to inflation during the period of saving.

If you are looking for a fixed-income product with a holding period of less than one year, the dividend plans of debt mutual funds score over fixed-deposits, especially if you are in the highest tax slab. The tax incidence is half of what it is in other deposits.

However, most people fear mutual funds due to their volatility in returns. How does one avoid volatility in mutual funds? Rather, how does one ensure that you do not incur a capital loss and also a basic minimum return?

The answer lies in fixed maturity plans (FMPs) of mutual funds. These mutual funds work exactly like fixed-deposits. You get a pre-determined return based on current market yields, of course, after deducting fund management expenses which are lower than regular debt funds as there is less churning.

Fixed maturity plans demystified What is a fixed maturity plan? A fixed maturity plan is an income scheme that allows saving only during the initial offer period that usually lasts from one day to one month and ceases to exist after a certain fixed duration. FMPs of one-month, three-month, one-year, three-year and five-year durations are periodically launched by mutual funds. They provide an easy route to invest in different types of bonds - government securities, corporate bonds and money market instruments through mutual funds. Saving in a fixed maturity plan is like knowing the exact day of harvesting a field on the day of planting the seeds. The harvest day is called the maturity date in the language of investments. Since saving in a fixed maturity plans is allowed only during their Initial Public Offering (IPO) period, and the savings are returned on the maturity date, these schemes are also called 'closed-ended schemes'. In contrast to these, saving in other 'open-ended schemes' is allowed throughout the existence of the scheme. Options available for withdrawal before the maturity date vary from scheme to scheme. These are specified in the offer document of the scheme. What are the advantages of FMPs? FMPs are popular because of their relative predictability. Their closed-ended nature allows fund managers to purchase bonds that pay back their investment on or around the maturity date and thus hold on to them till the end. This allows the fund to keep getting the agreed rate of interest on the bonds, effectively reducing what is called price risk (the potential for making a loss on bonds due to pressure to sell them off in the market). Though FMPs do not guarantee returns, a person who saves in an FMP has a fair idea of his indicative returns based on returns of similar duration bonds available in the market. How do FMPs manage risks? Debt investments are exposed to three broad kinds of risks: Interest rate/price risk/re-investment risk Credit risk Liquidity FMPs are able to mitigate most of the above risks by the very nature of their structure. They are less exposed to interest rate risk compared to other income schemes since instruments therein are typically held till maturity and hence yield a fixed rate of return which is equal to the yield at which investments were made. They also carry minimal liquidity risk as exit load is applicable for withdrawal before maturity. Hence, most investors withdraw only on the fixed maturity date of the scheme. -- Standard Chartered Mutual Fund

Since they hold instruments till maturity, they also minimise expenses. As there is no regular churning of the portfolio, this significantly reduces the overall cost of transactions.

Investors with a time-horizon of more than one year can actually end up paying zero tax by using a trick called double indexation. Double indexation gives an investor the advantage of indexing his investment to inflation for two years while remaining invested for a period of slightly more than an year.

This can be done if the investor puts in his money just before the end of a financial year and withdraws it immediately after the end of the next financial year.

How double indexation reduces your tax outgo The indexation table published by the income-tax authorities is a series of numbers for every year from 1981-82 that reflects the impact of inflation. For example, let's see the use of double indexation for Rs 10,000 saved in a fixed maturity plan that opened on March 31, 1995, and returned Rs 11,000 on closing on April 1, 1996. Thus the yearly return on savings is 10 per cent. Now the person who saved the money calculates tax payable at the end of the year in three steps. Calculate the Inflation Index by dividing the Yearly Inflation Index corresponding to the ending financial year by the Yearly Inflation Index corresponding to the starting financial year. For our example this will be 305/259 = 1.178. Multiply the amount invested with the Index. Thus, the amount invested will become Rs 11,780. This gives you the amount that is to be used as the initial saving for calculating the gain on which tax is applicable. Since the amount used as initial saving (Rs 11,780) has become higher than the amount returned (Rs 11,000), there is no gain on which tax can be applied. Thus, in our example, no tax is applicable when double indexation benefit is claimed.   1981-82 100 1982-83 109 1983-84 115 1984-85 125 1985-86 133 1986-87 140 1987-88 150 1988-89 161 1989-90 172 1990-91 182 1991-92 199 1992-93 223 1993-94 244 1994-95 259 1995-96 291 1996-97 305 1997-98 331 1998-99 351 1999-00 389 2000-01 406 2001-02 426 2002-03 447 2003-04 468 2004-05 480

Key takeaway: Short-duration fixed maturity plans (dividend plan) are ideal for less than one year. Thirteen month FMPs are best alternatives for one-year bank deposits. Do not commit yourself to more than one year of FMP as you run the risk of tax policy changes mid-way.

If finance ministers start looking closely at FMPs, they may simply stop allowing indexation benefits for debt funds and that will make your calculation go awry.

Home is where there is no tax
Owning a house is imperative. Not just owning, but owning one on borrowed capital. The key change that the Budget has brought about is that there is no longer any cap on the amount of principal repaid on your housing loan for tax deduction.

Under section 88, the limit was Rs 20,000. So your principal repayment alone can constitute the entire Rs 1,00,000 eligible for deduction. The deduction on principal repayment is over and above the deduction already available on housing loan interest up to Rs 1,50,000.

To put it simply, monthly installment of Rs 20,833 will be eligible for full deduction from your income if you have no other investments/expenses eligible for tax deduction.

For people who are paranoid about housing loans, you can derive solace from the fact that lowering your present debt is as good as saving for your future in the taxman's eye.

Actually, principal repayments can be a good alternative to savings. Since some part of your income as a salaried employee goes towards compulsory savings through your contribution to the employees provident fund, you can choose to simply reduce your debt burden to get tax breaks.

For those who thrive on borrowed money, there is no limit on the amount of deduction you can claim on the interest paid on loans taken for house property (after deducting rental income from the same) which is not self-occupied.

If the interest repaid is, say, Rs 5,00,000 in a particular year, this expense is fully deductible from your gross taxable income. So you actually end up paying no income-tax at all. Of course, you need to have a supplementary income to support your living expenses!

Currently, home loans rates are hovering around 8 per cent. If you are in the top tax bracket, your tax savings can be upto 30 per cent, meaning your effective cost of funds comes down to less than 6 per cent.

Key takeaway: Prepaying principal can be a good alternative to savings. People in the high income bracket can indulge in a second house to lower their tax burdens substantially.

Equity for the long haul
Another way to perk up your regular income is to invest a portion of your investments in equity-based dividend-yield schemes which invest in high-dividend paying stocks.

By virtue of the fact that their stock price is low in comparison to the dividend they pay (that is what makes the dividend yield high), the stocks are less risky. Since these are equity-based schemes, the dividend paid by them is tax-free.

When you buy and sell units of equity funds you pay a securities transaction tax of 0.2 per cent as in the case of equities. Short-term capital gains are taxed at 10 per cent while long-term capital gains are fully exempt from tax.

Currently, there are three dividend-yield funds available in the market, one each from Birla Mutual, Principal PNB Mutual and Tata Mutual Fund.

Besides, equity linked savings schemes are also a must-invest proposition now. The fact that investment in ELSSs entails a tax saving of upto 30 per cent (if you are in the top bracket) is to say that you can buy equities at a 30 per cent discount or that you earn a 30 per cent return on day one of investing.

Thus, ELSS can be an excellent alternative to investing directly in stocks. The prudent way to invest in ELSS is to commit a regular amount every month towards purchasing units of ELSS rather than bunch investments and buy units towards the end of the year.

This will not only ease the burden towards the end of the year but also average out your cost of acquisition of shares since you would buy more units when the markets are high and less when the markets are low.

Key takeaway: ELSS is smarter than direct equity purchases for most people.