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Losing tax benefits on early withdrawal

Losing tax benefits on early withdrawal

Watch out when making an investment purely for its tax benefits. The income you receive is taxable if you withdraw it prematurely. This applies to ULIP and endowment policies as well.

It’s a pity that we quickly agree to invest in a scheme after hearing about its tax benefits. It automatically gains points for being tax-free even if the earnings are to be taxed at just 10%. Perhaps you are not to blame; financial advisors can be very convincing when they recommend such products. But without analysing the product in its entirety, you shouldn’t make a decision. In fact, if you realise the investment isn’t suited to you, you would even lose the tax benefits you thought you bagged in the past.

Termination of EPF account
The employee provident fund is a great way to save on tax. The principal and interest up to a limit of Rs1 lakh a year is left untouched by the Income Tax Act under Section 80C. It almost seems like a no-brainer if your employer asks if you wish to opt-in. The trouble, though, is that if you take a break to study within five years, are unemployed in between jobs or simply wish to withdraw your EPF, the tax benefit stands withdrawn. The principal and the interest gets taxed.

Withdrawal from FDs/SCSS
Five-year FDs and the Senior Citizens Savings Scheme may seem like attractive options, particularly at this time, when interest rates are so high. But remember that both investments are subject to a lock-in of five years. If you break either deposit prematurely, you lose the tax benefits immediately. Not just the interest, the principal would also be taxed at the slab rate.

ULIPs are often sold for their tax benefits alone, with agents claiming that you can withdraw your money once you complete five years. Within two years, though, it may become apparent that the ULIP is too costly in the beginning to turn any profit in the first few years. In fact, you could easily be deeply in loss after the first two years. A costly mistake just for a deduction under Section 80C. You may think that you should just book your losses and exit the scheme, but remember to also factor in that it will also cause you to lose any tax benefits you booked earlier. Tax breaks are withdrawn completely if you don’t pay premiums for the full lock-in period.

Other insurance policies
While the (new) ULIP has a fixed lock-in period of five years, traditional (endowment, for example) and term insurance policies have no such lock-in. With them, you must pay at least the first two premiums to keep the benefits from being revoked.

Selling tax-free bonds
Tax-free bonds are long-term in nature, with terms of 10 to 20 years. If you’re looking to stick with the scheme until maturity, you will pay no tax at the end of the term. This benefit is lost, though, if you need the money prematurely, so long as you make money from the sale. Gains from the sale of the bonds in the secondary market are taxed on a short- or long-term basis.

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