Union Budget 2020 wants you to spend more. The Finance Minister has announced income tax cuts, however, to avail these, you will have to forgo all the deductions you received from taxable income by way of investing in various financial products.
The article below is really about making the most efficient choice of investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More product. But before we get to that, now you must also consider making the right choice of the tax slabs you want to pick. The Government now gives you a choice to either stick with the old income tax slabs and continue to choose your deductions to lower the taxable income or alternatively, you can choose the new income tax slabs and forgo your deductions. The latter is going to hurt you. Basically, you don’t save anything and just spend whatever you earn or pay it as tax.
Firstly, the math shows that it is not more tax-efficient to choose the new tax regime if you claim deductions like housing rent allowance (HRA) and Section 80C linked deductions; MINT has done a very informative graphic on this, which you can view below:
Simply speaking, if you earn ₹10 lakh a year, under the new option for income tax calculation, you will end up with a tax payable of ₹78,000 without including any deductions and exemptions. This compared to a tax payable of ₹75,400 under the old system, including ₹1,50,000 (maximum allowed deduction) invested under Section 80 C. This is even without accounting for things like HRA. My advice would be to stick to the old system of tax calculation for now.
Which, brings us to the next problem. Where should you invest to take advantage of the ₹1,50,000 deduction available under IT Act Sec 80C?
READ ON…
You’re in the early to mid-20s, just got your first job and come tax season are wondering where to invest to save some tax. An elder in the family or at work tells you about the great Public Provident Fund option. You can invest up to a maximum ₹1,50,000; whatever amount you invest up to this limit is tax-free. The annual interest you earn is tax-free and so is the final withdrawal amount after 15 years.
This is the only investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More option which has zero tax liability and offers a guaranteed, defined return. Ticks all the boxes doesn’t it?
The next question you may have is how much is the return and what’s this about 15 years?
…Explaining PPF
The current annual interest on PPF is 7.9% which means that for every ₹10,000 you invest – you will get ₹790 each year. This is great, considering that the one-year fixed deposit interest rate is around 6.5%-7% and that too will get taxed. Definitely, better than a fixed deposit. However, the investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More in PPF needs to remain locked in for 15 years! Yes, you have to keep it in for 15 years. And if you invest next year again, then again you will have to keep that investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More for another 15 years.
Okay, the long lock-in may be a bummer, but hey its tax-free and guaranteed! Got anything better?
…Have you heard of real return?
In an earlier post, I explained the concept of inflation and how it reduces the value of our money. Thanks to inflationInflation is a common term thrown around in economics lessons and by politicians around election time. What it means in simple language is that prices of things you buy, stuff, keeps increasing every year. It happens because the economy in... More, every year your money is worth less than what it was the previous year. Hence, any investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More product needs to yield at least more than the rate of inflationInflation is a common term thrown around in economics lessons and by politicians around election time. What it means in simple language is that prices of things you buy, stuff, keeps increasing every year. It happens because the economy in... More so that on a net basis your money grows. In a growing economy like India, a reasonable estimate of average inflationInflation is a common term thrown around in economics lessons and by politicians around election time. What it means in simple language is that prices of things you buy, stuff, keeps increasing every year. It happens because the economy in... More for the next decade is around 6% annually. Assuming this rate, your net return from PPF will be around 1.9% annually (if the rate is not revised; which does happen every 3 months). This return, net of annual inflationInflation is a common term thrown around in economics lessons and by politicians around election time. What it means in simple language is that prices of things you buy, stuff, keeps increasing every year. It happens because the economy in... More is called the real return.
Still excited? Basically, you will leave money in for 15 years to earn 1.9% or thereabouts real return each year.
…But is there anything better?
It is a riskier option, but historical data shows us that the 15-year return from an equity mutual fund can be far better than PPF. Not only that, the investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More is withdrawable at any time in between if you need it.
Ever heard of an equity-linked savings scheme (ELSS)? These are equity diversified mutual funds which also qualify for the ₹1,50,000 exemption from income tax (under Section 80C). There is no defined interest in case of equity funds, but the longer you leave the money invested the more wealth you create thanks to profits accumulating and compoundingCompounding is the concept of earning return on both your principle investment and your profit. It is a way of calculating return that assumes you pull back your return till yesterday and remain invested so that any change in value... More over time. For a 15-year period, a 12%-15% annualised return is not far fetched in these funds (see graph). There is a 10% tax applicable on gains, which will bring the return down to a range of 10.8%-13.5% annualised. This is still much better than the 7.9% you are looking at in case of PPF and translates to a real return of 4.8%-7.5%.
What you need to do is remain invested for as long as you can to maximise the potential returns. Secondly, don’t panic when you see interim drops in your fund value. The one thing that works the best for equity investments of all kinds is time. Give it time. Treat it like a business venture which needs to accumulate profits over time.
…What you need to be careful about
ELSS funds do have a 3-year lock-in, during which time you can not withdraw the funds. While you must not remain invested in poor-performing funds, be sure to switch to another ELSS if you have to and don’t keep adding different schemes or switching too often, as that comes at a cost too.
While the maximum level of investmentAn investment is made to give you a return. You make an investment if you use your money to buy either physical assets like property or financial assets like bonds and equity with an aim to receive income or gains... More for getting a tax exemption is ₹1.5 lakh, you can go ahead and invest even more in the same ELSS fund – there is no annual limit.
At the end of this article, I would once again like to reiterate that planning your savings is a lot more important at a young age when you don’t have any baggage and responsibilities, rather than later.
Don’t fall for the consumption drive that the Budget 2020 wants to induce, stick to the current tax slabs and keep your forced saving and investments alive.