How to avoid tax saving traps set by unscrupulous wealth managers, bank officials
An average investor neither has the time or the inclination to go into the finer details of the policy.
Looking for a tax-saving option? How about a plan that gives your tax savings, provides tax-free income at regular intervals and gives a big lump sum on maturity?
Plus, you also get life cover. If a 35-year-old man invests Rs 65,000 every year for 20 years, he will receive four instalments of Rs 1.5 lakh each after the fourth, eighth, twelfth and sixteenth years and a lump sum Rs 5 lakh on maturity after 20 years. Besides these guaranteed payments, he will also get a simple reversionary bonus of about Rs 3.8 lakh. What’s more, in case he dies during the term of the plan, his nominee will get Rs 10 lakh.
Sounds good? At first glance, this money-back plan from a large life insurance company certainly appears lucrative. But the reality dawns once you analyse these numbers in detail. We found that the internal rate of return (IRR) was a miserly 2.23%. That’s less than what a savings bank offers.
Insurance companies argue that an insurance plan also offers life cover so the returns will obviously get impacted. That’s a fair point. So we factored in the cost of life cover by reducing the premium outgo. A term cover of Rs 10 lakh would cost around Rs 3,000. Even if we factor in the cost of the life insurance cover, the return generated by the policy is 2.79%.
Would you invest in a plan that promises less than 3%? Despite the poor returns, lakhs of money-back policies and endowment plans get sold during the tax planning season every year. This is because the average investor neither has the time or the inclination to go into the finer details of the policy. Prodded by his employer to show investment proof by the deadline and impressed by the rosy picture drawn by the insurance salesperson, he just wants to get over with it as quickly as possible.
The result? A lot of heartburn and complaints against the insurance company. Not surprisingly, most of the complaints received by the insurance ombudsman relate to misselling. The annual report of the Executive Council of Insurers notes that in many cases buyers are sold long-term plans even though they can’t pay the premium after the first year. This week’s cover story looks at some of the traps laid out by wealth managers and bank executives to trick taxpayers into unsuitable investments. We look at the modus operandi of these players and the lures they use. Read on to know how you can avoid getting trapped.
I. What they say: “This plan is just like an ELSS fund, but also provides life insurance cover.”
What they hide: “It is a Ulip and the life cover is not free. You will be charged for it.”
This is the favourite line of bank executives when you approach them for a taxsaving option. In recent years, investors have woken up to the benefits of equity investing.
But if you buy an ELSS fund, the bank gets a very thin slice of the commission cake. So they lure you with talk of free insurance cover with mutual fund. This insurance is not free though, and the investor pays mortality charges. A Ulip may not fetch a fatter commission because charges have now been capped, but the plan requires a multi-year commitment. Whether you like it or not, you will remain invested for a longer period. Even if you decide to exit after a few years, you will have to cough up surrender charges. The other problem with a Ulip is that you don’t have the same flexibility and choice that a tax-saving mutual fund offers. Investors in ELSS funds are not compelled to remain invested in a scheme for the long term or compulsorily withdraw once the scheme matures.
The trap: Ulips are not flexible like ELSS funds. There is a five-year lock in and though surrender charges have been capped, you still end up paying a lot for ending these plans prematurely.
II. What they say: “This scheme is launched by the bank and is therefore, very safe and reliable.”
What they hide:“It is a life insurance policy from a company promoted by the bank.”
Banks, especially PSU entities, enjoy a lot of trust among their customers. And nobody knows how to cash in on this better than insurance distributors. Around this time of the year, customers are bombarded with SMSs about lucrative savings plans that can cut tax.
The messages seem to suggest that the plan has been launched by the bank, even though it is an insurance policy from a company in which the bank is a promoter. They do so because customers tend to be wary when it comes to insurance plans, but will happily invest in a scheme from their bank. “This amounts to misleading the buyer. This practice is rampant in Tier II and Tier III towns, where financial awareness is low and investors place trust in their banks,” contends Mukesh Kalra, CEO of ET Money. In most cases, the buyer realises that he has been trapped much later when the policy is already in operation and cannot be terminated without suffering a heavy loss.
The trap: The distributor projects the policy as a scheme from the bank to make it appear reliable and lucrative.
III. What they say: “This plan is just like a fixed deposit but gives tax-free returns and insurance cover.”
What they hide: “It is an endowment insurance policy and the returns will be very low.”
Many taxpayers, especially senior citizens, do not want to lock up their money for the long term. They prefer tax-saving fixed deposits because they are very safe and have a lock-in period of five years. But the interest from tax-saving deposits is fully taxable at the marginal rate applicable to the investor. In the 30% tax bracket, this brings down the post-tax return close to 5%. Relationship managers exploit this poor tax efficiency of fixed deposits to offer taxpayers an investment option with “tax free returns”.
This is actually an endowment insurance policy. The taxpayer is given the impression that he is investing in a fixed deposit whereas he gets trapped in a multi-year premium commitment. The worst hit are older taxpayers who don’t have enough liquidity to pay the premium every year. At one time this had become such a big problem for senior citizens that the insurance regulator changed the rules. Many endowment policies now have an upper age limit of 50 years.
The trap: Endowment policies offer very low returns, require a multiyear premium commitment and have very high surrender charges.
IV. What they say: “Investing in NPS is complicated. This pension plan is much better.”
What they hide: “Pension plans from insurers have much higher charges than the low-cost NPS.”
If you ask any bank executive about the NPS, be prepared to get a blank look. It’s been almost 10 years since the pension scheme was thrown open to the general public, but wealth managers and relationship managers in banks have little knowledge how it works and how one can start investing in it.
Even if they know the process, nobody wants to promote the low-cost NPS. The pension scheme offers an ultra-thin commission to the intermediary. Instead, most bank executives will push pension plans from insurance companies. And not without a reason. These regular pension plans have much higher costs than what you pay when you invest in the NPS. Even their online versions, which should not have a high cost structure, have significantly higher charges than the NPS funds. One plan, for instance, has an “investment guarantee fee” in addition to the fund management charge
The trap: Exiting the pension plan is not easy. Apart from the lock-in period, you have to pay surrender charges.
V. What they say: “Invest in ELSS to save tax and gain from the rise in the stock market.”
What they hide:“ELSS funds are market linked. It is not advisable to put a large sum at one go.”
ELSS funds are undoubtedly one of the best ways to save tax. Apart from saving tax under Section 80C, the taxpayer is able to create wealth by investing in these equity funds. The ELSS category has delivered annualised returns of 16.5% in the past five years, making them the highest wealth creator among all tax-saving instruments.
The 10-year annualised return is even higher at 17.5%. At the same time, it is not advisable to invest a large sum in equity funds at one go. The best way is to start an SIP of Rs 5,000-10,000 at the beginning of the financial year so that the ups and downs in the market get absorbed over time. “SIPs is another form of diversification. They spread your investment across time, thus reducing the risk,” says Raj Khosla, Managing Director of MyMoneyMantra. But wealth managers will not tell you this when you ask them for a tax saving option. Instead, they want you to invest at one go so that there is no possibility of you stopping the investment or changing the fund after 3-4 SIPs.
The trap: You can’t do anything before the three-year lock in period. Best to start SIP in ELSS fund at the beginning of the financial year.