Tax-saving Instruments Vs Tax-free Instruments: Which are more beneficial for you?

Before starting investing, you should have a clear concept about tax-saving and tax-free features associated with different investment instruments and the differences between these features before choosing an instrument.

Tax-saving only Instruments

The tax-saving feature of a scheme helps an investor claim deductions from the taxable income by investing in the scheme, subject to the upper limit of deductions set by the government.

Having a tax-saving feature, however, doesn’t mean that there will be tax exemptions on the interest or returns or gains from the instrument. The interest / return / gain and the maturity value of such an instrument may be tax-free or may not be.

The examples of some tax-saving financial instruments having taxable interest / return / gain are tax-saving fixed deposits (FDs), Senior Citizen Savings Scheme (SCSS), National Savings Certificate (NSC), Prime Minister Vaya Vandana Yojana (PMVVY), pension schemes of life insurance companies, tax-saving bonds, etc.

Tax-free only Instruments

The tax-free feature of an instrument makes the interest or return on the instrument tax free and the investor needn’t pay any tax on maturity.

It’s not necessary that the tax-free nature of the interest / return / gain and maturity value of an instrument would entail an investor getting tax-saving benefits on the amount invested in the instrument.

There may or may not be any tax-saving benefits on investments made in a tax-free instrument.

Some of the examples of instruments having tax-free maturity, but no tax-saving benefits are tax-free bonds, Sovereign Gold Bonds (SGB) etc.

Instruments having Dual Benefits

Although it’s not necessary that a tax-saving scheme will have tax-free interest / return, or a scheme having tax-free feature will also help in tax savings, there are very few schemes that have both the features and they come under the EEE category (that is tax exemptions on investment, interest / return and maturity).

Some of such instruments having both tax-saving and tax-free features are Public Provident Fund (PPF), Sukanya Samriddhi Yojana (SSY) and Unit Linked Insurance Plans (ULIPs).

Tax-saving Instruments with Partially Taxable Returns

There are also some instruments that have tax-saving features and partial tax relief on maturity / redemption. For example, National Pension System (NPS) Tier-1 Accounts, Equity Linked Savings Scheme (ELSS) etc.

Which is more beneficial?

There is no doubt that the instruments having the EEE feature – that is, tax benefits on both investment and maturity – are the most beneficial instruments. However, such instruments generally have capping on maximum investments, so can’t be availed after a limit.

So, in case your investment capacity is within the limit, EEE categories would be the best. However, to meet your financial goals with limited investments, you may have to consider some other investment avenues giving higher returns.

On the other hand, if you have already exhausted the limits of EEE instruments, the instruments having tax-free features would be the best for you. For higher gains, you may also invest in the instruments having partial tax benefits on maturity.